A Long Way to Go – China's Limited Partner Market

In the private equity world, there are two basic roles. There is the General Partner (GP), who is responsible for operating the fund and in most cases is the management team or the management company, and there is the Limited Partner (LP), who contributes the largest share to the fund, usually more than 90%. To put it in simpler terms, limited partners are like shareholders, while general partners are like the management executives in a corporation. There are other kinds of relationships or corporate structures when establishing a fund, such as the trust fund approach or limited company approach, but I won’t discuss those in this article.
When a fund is trying to raise money, the very first question they may ask themselves is “from whom should we ask?” In my opinion, there is no complicated or mysterious theory or criteria behind the answer to this question. The most critical factor is trust. You need to find partners who believe in your capability and share the same view of your investment strategy. Just like in the greater business world, trust is the foundation for success.
I recently read an article about the history of the Shenzhen Capital Group, one of the most successful venture capital and investment groups in China today, who nevertheless had a very tough time raising their first and second funds in 1999 and 2000. No one in China at that time understood venture capital or private equity, and no one believed that a state owned investment company could generate profit. Despite their difficulties, Shenzhen Capital surprisingly turned down an offer from Mr. Zhou Zhengyi, the richest man in Shanghai at that time, who was willing to subscribe 20% of the total fund amount. Why? I think that what was missing at the time was mutual trust. In fact, just one year later, Mr. Zhou Zhengyi was arrested for bribery and corruption. If Shenzhen Capital Group had received the investment from Mr. Zhou at the time, they would never have become as prestigious as they are today.
Let’s have a look at the private equity market in China today, a decade later:
How many private equity funds do we have now in China? The official number is 3,000, but there may be 3,000 funds just in Shenzhen, and the real number may be over 10,000, thousands more than 10 years ago. And how many limited partners? Strictly speaking, there is only one genuine LP in China – the National Social Security Fund (NSSF), which began to invest in private equity funds just three years ago. Other kinds of LPs include local governments, large state-owned enterprises or financial institutions, rich individuals, and private companies, which are not all stable sources of money. The huge development gap between the GP market and LP market is a severe problem for China’s private equity industry. Our LP market is not only small in terms of size, but also immature in terms of professionalism.
Local governments are willing to invest in a fund only if the management team can promise to raise more money and invest most of the money in the region where that administration is based.
Large state-owned enterprises or financial institutions are very powerful in China, and their penchant for power is evident when they become LPs. They are used to having a great deal of influence over the management team and each investment. Moreover, they would feel more comfortable if they could control the management company and appoint or hire their own people to join the management team.
Individuals and private companies are relatively easy to negotiate, but the pressure they exert on the GP may be even higher than local government or SEOs. The only thing they care about is earning money and earning it fast. They usually have very limited patience, because to them it seems that private equity is an easy but lucrative job in China. Three times in three years is something weighing on their minds.
The result is that we have LPs who love to act as GPs, and who focus purely on short-term returns. Under such circumstances, finding a suitable and qualified LP in mainland China, who also trusts each party, is an incredibly challenging task. There is a long way to go before we can overcome the problems in our limited partner market, but I hope we do not wait too long.