Yuan Funds May Be More Illusion Than Oasis

Yuan Funds May Be More Illusion Than Oasis

By PETER STEIN

Many private-equity funds are convinced that investing in China with the country's own currency will help them crack a market long on promise and short on deals. They may yet face disappointment.

Leaders of Japan, China and South Korea met to speed up preparations for a three-way free-trade pact, while the private-equity world is abuzz over yuan-denominated funds. WSJ's Peter Stein and Jake Lee discuss.

For the last few years, funds denominated in yuan, also called the renminbi, have become all the rage in China's private-equity scene.

Goldman Sachs Group Inc. and Morgan Stanley are the latest players to jump into the fray. Goldman recently signed a deal with the Beijing government for a five billion yuan ($770 million) fund. Last week, Morgan Stanley opened a 1.5 billion yuan fund with a partner in Hangzhou. They join TPG, Carlyle Group and Blackstone Group LP, which have all announced yuan funds of their own.

One of the biggest attractions of yuan funds is that, in theory, Beijing treats them like domestic investors. They hold domestic currency sourced from domestic institutional investors and wealthy individuals. That frees them from the red tape and other restrictions that bedevil foreigners who set their sights on a Chinese company.

Yuan funds are in the process of raising some $25 billion worth of capital, estimates Bain & Co., the consulting firm.

.Altogether, yuan funds are in the process of raising some $25 billion worth of capital, estimates Bain & Co., the consulting firm. "We're inundated with this work," says Larry Sussman, managing partner at O'Melveny & Myers LLP in Beijing, who works with private-equity funds in China. "Everyone is coming in and setting up."

Most firms are still in fund-raising mode, and very few if any have actually put any Chinese money to work.

But already, firms that manage dollar funds and are setting up yuan funds, too, are grappling with a conundrum: How do you convince your foreign investors—referred to as limited partners, or "LPs," in the private-equity world—that you are keeping their best interests at heart while you scour China for deals to invest in with renminbi?

Foreign LPs already had reason to worry that things weren't going in their favor. When it involves foreigners, approval for an investment in China can take 18 months or longer. Also, more and more companies in China are reluctant to take foreign money because doing so complicates their ability to go public in Shanghai or Shenzhen, thanks to arcane Chinese listing regulations.

That's a problem when you consider that new foreign dollar funds focused on China announced plans to raise $60 billion last year, according to Bain, yet existing funds managed to invest only around $11 billion. Piles of money seeking returns from China are building up, and much of it is going nowhere.

One solution is to bring foreign LPs into the yuan funds, aligning their interests with those of the domestic LPs. Earlier this month, Shanghai authorities announced a pilot program designed to allow just that. Carlyle and Blackstone are among the five firms participating.

There's a catch though. Yuan funds that take money from foreign investors are treated, well, like foreigners. That means they will be subject to foreign investment regulations and restrictions, says Yong Ren, a lawyer for Mayer Brown JSM in Beijing. A deal to invest in a Chinese company, for example, would need sign-offs from China's Ministry of Commerce and the National Development and Reform Commission.

In other words, you sacrifice one of the main attractions for setting up a yuan fund in the first place. What's worse, a Chinese LP putting money into the same fund might resent the fund being hamstrung because of its foreign taint.

That's why some firms with yuan funds say they would rather remain "pure." Even for those, it remains to be seen whether the ones owned and run by non-Chinese fund managers will be treated on par with the locals when it comes to doing deals or receiving support from state-owned LPs, like the big life insurers or the national social-security fund. Private equity wouldn't be the only industry in which Chinese officials promoted local champions at the expense of foreign rivals.

It's not all so grim for the foreigners. Some have wrangled profitable deals before, and some will find smart ones in the future, despite the obstacles. Many Chinese firms will still seek out not just the funds with fat wallets, but those with expertise in management and restructuring, says Vinit Bhatia, a partner in Bain's Asia private-equity practice. So will the firms that want help building a presence overseas.

Does it hurt to have a renminbi fund? Some of the biggest names in Western private equity have already concluded that, on balance, it can only help—just maybe not as much as they would wish.

Write to Peter Stein at peter.stein@wsj.com