China Cracks Down on Foreign Private Equity

Implications: This week, China blocked a bid by private equity fund Carlyle to take a stake in a city commercial bank. This reflects a new phase of development for China's banking sector. Foreign financial sponsors will now be able to invest only in those parts of the financial that lack both capital and sufficient domestic interest.

Analysis:

Last week, China's banking regulator, the CBRC, blocked a bid by Carlyle, the US-based private equity firm, to acquire an 8% stake in Chongqing City Commercial Bank.

The decision made the headlines and sent chills through the private equity community, many of whose members have been long courting banks and other financial institutions in China.

Bank Limits

By law, foreign investors are limited to owning 25% of Chinese bank, with no one investor owning more than 20%. That limitation has caused considerable angst among investors who fear that lack of a controlling interest may be subject to the vagaries of current managements’ decisions. But many financial institutions—Bank of America, Deutsche Bank, Citigroup, Goldman Sachs, and others—have bought significant stakes in Chinese banks. Some of those banks have subsequently floated on domestic and international equity markets, making vast paper profits for foreign investors.

But to date, there have only a couple notable investments by private equity in Chinese banks. Newbridge Capital bought roughly 18% of Shenzhen Development Bank several years ago, and the IFC, Temasek, and Pangea have taken small stakes in some city commercial banks.

Flush with Capital, Short of Skills

But with last week’s announcement, it is clear that PE will no longer be approved to invest in banks. Regulators—and many bank executives—see PE firms as providing only capital, and therefore they are of little use in reforming China’s banking sector.

In part, this is because Chinese banks don’t need capital. Notwithstanding their history of non-performing assets, most Chinese banks are flush with cash since some 70-80% of financial intermediation in China goes through the banking sector. Additionally, in many cases, their balance sheets have been strengthened through government recapitalization, forced consolidation, and/or improved management.

It is also because Chinese authorities believe that they are on the right track in tackling the banking sector. Since reform started in the late 1990s, the government has, by most accounts, been relatively successful in its sequential strategy of (i) balance sheet recapitalization, (ii) introduction of strategic partners, and (iii) public offerings on major exchanges. Three of the four big state banks and several joint-stock banks have been successfully reformed this way; city commercial banks (particularly Nanjing and Ningbo) are close on their heels.

The large and fundamental problems that remain in China’s banking sector cannot be solved by money. They can be solved by enhancing management capacity, improving technology, and ending state interference in credit decisions. The first two problems can be addressed by strategic rather than financial partners. This leaves foreign private equity at a disadvantage to foreign commercial banks.

Indeed, only one week after the Carlyle bid was blocked, Intesa Sanpaolo, an Italian bank, received approval to take a stake in Qingdao City Commercial Bank.

Domestic PE Heats Up

At the same time, the Chinese government has been focusing on the development of domestic private equity. China's securities regulator, the CSRC, convened a meeting in June to "create regulations that give PE funds a complete strategy for selling investments domestically." Domestic PE firms are not subject to shareholding restrictions and can ignore capital controls and currency risks. At the same time, local investors are often favored by target managers for nationalistic, cultural, and valuation reasons.

These factors, along with the need for technology and management rather than capital in China’s banking system, have left would-be foreign buyers in a bit of a lurch.

What’s Left

Given the predilection of the CBRC to favor strategic over financial investors for China’s banks, where can PE enter the financial sector and add value? There are two areas.

First, non-bank financial institutions like trust companies, leasing, and auto finance are in need of investment. The NBFI sector has remained largely off the radar screen of regulators, and this lack of attention has caused the sector to fall into some disrepair. Large swaths of both capital and management skills are needed to bring it back into China’s financial system. For that reason, PE firms are likely to receive a warm welcome should they be interested.

Second, rural financial institiutions are in dire need of capital and skills. The central government’s emphasis on creating a harmonious society may mean that restrictions investments may be suspended to allow the country’s rural financial system to grow. PE could also take advantage of this sector.