In contrast to the period directly following the global economic crisis, private equity (PE) has been a hotbed of activity in Asia in 2010, as exit opportunities have increased and the mergers and acquisitions (M&A) wave continues. The major players in the industry have introduced RMB-denominated funds in order to invest in China, while the latest developments point to the introduction of international capital in RMB funds. On a wider basis, investing in Asia presents its own distinct challenges and certain sectors such as infrastructure and resources are running particularly hot at the moment.
Anyone participating in these markets recently could not fail to notice the voracious appetite with which China is buying assets in the region at the moment. One particularly significant development has been the emergence of the China ASEAN Investment Corporation Fund, established by a number of China's state owned enterprises in April 2009 in order to invest in ASEAN countries with a target size of US$10 billion.
Aimed at promoting economic cooperation between China and the rest of the ASEAN region, the fund had its first closing in April 2010 and already has US$800 million committed. Key sector focuses for the fund are infrastructure, energy and resources, including toll roads, airports, ports, power generation, renewable energy, oil pipelines and telecommunications. With Asia acting as a growth engine for the global economy and the strong population growth in the region, the activities of the China ASEAN Fund is a key dynamic in the private equity industry in Asia, particularly with high demand for infrastructure resulting in significant opportunities for private capital.
As Asia is such a diverse continent, infrastructure specialists see a great range of opportunities and significant potential in this area. However, there are challenges due to the sheer number of countries which are at different stages of development, while different regulatory frameworks compound the issue. For example in some countries, such as Cambodia or Vietnam, there is a need for power plants while other countries need to build toll roads, meanwhile projects in more developed countries like Singapore and Malaysia include oil storage developments and metal mining. Elsewhere, the investment of choice in Hong Kong is probably real estate and this is likely to continue over the next couple of years, particularly the commercial sector including offices and shopping centres.
Many of the leading private sector names have been looking at outbound M&A in the current market conditions, with favourable exchange rates providing an opportune time for portfolio companies in buyout funds to invest in bolt on acquisitions of undervalued European or US companies. There is a feeling among the industry leaders that such ideal conditions to acquire expertise or market share may not come around again for some time, with the enterprise value of target assets now at a fraction of the levels they were two years ago, while Chinese operations are holding significantly more cash than they were in 2008. German, South African and Japanese assets are all in the frame, however managers are always conscious of the potential integration issues with cross-border M&A. The point has also been made that in this post-Lehman Brothers world, private equity funds are picking up just the kind of assets that would have previously been looked at by the investment banks.
From Walkers' perspective in Hong Kong, we have seen a significant increase in private equity work across the region. Fund formation has come back strongly since late 2008/early 2009 and the fundraising which had stalled has now managed to make progress with some closings. There have also been some significant new entrants to the market such as the China ASEAN fund. In terms of downstream investments there has been significant activity in pre-IPO equity as well as debt financing, in addition to mergers and schemes of arrangement. Aside from traditional sales and purchases we have also seen clients taking advantage of the merger regimes in the Cayman Islands and BVI, allowing statutory mergers where one or more entities can be merged into, or consolidated with, existing or new entities.
As for inbound investment into China, the topic creating significant interest in the industry in recent months is Circular 698, the new tax law which took effect from January 1, 2008 and was applied retroactively. Circular 698 covers the indirect transfer of shares in an offshore holding company that holds an underlying PRC investment and where the offshore SPV is located in a jurisdiction that has an ‘effective’ rate of taxation below 12.5 per cent or does not tax its residents on overseas income. The traditional offshore private equity investment structure had a private equity fund set up a Cayman Islands or BVI holding company with a wholly-owned Hong Kong subsidiary, which in turn owns the underlying PRC businesses. A transfer of shares in such offshore holding company will now attract a capital gains tax of 10 per cent whereas traditionally, the sale of a Cayman Islands company had not given rise to any PRC tax.
On a practical level, funds investing in the PRC are having to factor Circular 698 into their pricing, while advisory boards and LPs are now aware of the issue and understand the implications. A view among leading funds is that overall, LPs are not too concerned with a 10 per cent capital gains tax providing that the overall investment strategy and the quality of the investment are good. It is a case, therefore, of pricing the tax into the exit price and IRR and factoring it into a deal structure. Elsewhere, managers are examining the structure of Hong Kong and offshore companies to ensure that a substantive business exists, although this may present practical difficulties as typically holding companies are established for each investment to avoid cross contamination.
Also generating significant attention in Asian PE circles has been the proliferation of RMB funds, which have been established by a greater number of the key PE players. In considering the role that offshore funds will play in the midst of this development, one of the key issues for investors has been deal allocation. With both onshore and RMB funds investing into China there is a need to take into account the rights of investors to have their fund invested in a particular opportunity. Some players have argued that there is still demand for foreign capital to support expansion and internationalisation, and for such sponsors offshore funds are still preferred. Of course for PE houses working on inbound M&A to China, RMB funds can be very useful because when deals are based in China it is a natural progression to tap into that liquidity and RMB funds can provide that platform. Overall, RMB funds are a very important development in China in terms of driving the private equity industry forward, but the choice between offshore and domestic funds depends upon the asset class, the stage the fund is at and what investors are looking for. At this point in time it seems there is room for everyone.
A particularly interesting recent development in this sphere, meanwhile, is the prospect that international capital will be permitted to participate in RMB funds, which will significantly increase the range of investment opportunities for overseas investors, while at the same time providing new capital sources for RMB funds. It is understood that local pilot programs are being developed with Chinese authorities in Beijing, Shanghai and Tianjin under the 'Qualified Foreign Limited Partners' (QFLP) regime. Initial details indicate that international institutional investors that meet certain criteria will be allowed to invest as limited partners or shareholders in RMB funds. This regime will go some way to alleviating the potential conflicts of interest regarding deal allocation, potentially allowing the combination of international and domestic capital into one vehicle, so this is certainly an area to keep an eye on in 2011.
Walkers Bermuda, British Virgin Islands, Cayman Islands, Dubai, Guernsey, Hong Kong, Ireland, Jersey, London and Singapore.