EXIT VIA IPO IN CHINA

An examination of the exit environment

DECEMBER 20, 2010

TABLE OF CONTENTS

Key Findings 4

Project Overview 5
Methodology 5
Overview of Ergo Teams 5

Introduction 6

1. Capital Market Developments 7

Evolution of the Market 7
Participation of Chinese Investors – Retail & Institutional 7
Requirements to Improve Quality of Liquidity 10

2. IPO Exits: Chinese vs. Global Exchanges 13

Trends in Listings 13
PE-Backed IPOs – Valuations and Exit Multiples 14

3. Regulatory Environment 17
The IPO Approval Process – A Black Box 17
Looking Forward 19

4. References 20

About Ergo 22

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 KEY
Methodology
KEY FINDINGS

FINDINGS
This study provides a primer on the exit environment for private equity investors in China, with a particular focus
on the prospects for exit via IPO for foreign General Partners (GPs). Our Key Findings from the study include:

• China’s IPO markets show tremendous potential, however they remain prone to the whims and irrational
exuberance of domestic retail investors. Beijing is trying to develop its institutional investor base to mitigate
volatility, and the process of professionalizing asset management will take a considerable amount of time.

• Chinese enterprises increasingly list IPOs onshore, as valuations on domestic exchanges offer much more
favorable exit multiples. Hong Kong is the preferred exchange for offshore listings.

• Despite Beijing’s declarations of encouraging foreign investors to list domestically, many foreign GPs believe
the regulatory process remains a “black box” with unclear guidelines.

• Competition for listing on China’s exchanges likely will get more heated as municipalities increase their
involvement in private equity. GPs will need to have a keen understanding of the local political and economic
policies and government interests in order to successfully exit their investments.

• Beijing’s likely response to its concerns over frothy real estate prices and Consumer Price Index (CPI) infla-
tion could reduce equity returns in the near-term. The People’s Bank of China – China’s central bank – is
increasing reserve requirements at Chinese banks to drain the economy of excess liquidity, putting downward
pressure on equity prices.

• Experts generally believe stability will return to Chinese equity markets over the next 2-5 years, with ample
demand for IPOs. The Chinese government is likely to continue its process of financial sector reforms, to include
facilitating the process for foreign-owned portfolio companies to list an IPO on Chinese exchanges.

• Capital markets experts anticipate the addition of an international bourse in Shanghai within the next 1-2
years.

• The change of government at the end of 2012 could usher in a new government that is less favorable to finan-
cial sector liberalization and reforms than the current one. GPs and LPs should begin assessing the potential
impacts of a shift toward a less market-friendly government on their exit prospects.

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 Methodology
Overview
Project
PROJECT OVERVIEW

METHODOLOGY
This report addresses the prospects for private equity investors to exit their investments via IPO in China. The report is
the result of Ergo’s work with our teams of private equity professionals, lawyers, and other experts on China’s capital mar-
kets. Ergo conducted this review of China’s IPO market at the behest of the Emerging Markets Private Equity Association
(EMPEA). Ergo conducted in-depth conversations with our experts from November 10th to November 30th 2010.

• Ergo conducted a survey with our experts to attempt to quantify perceptions of regulatory hurdles, and the likeli-
hood that the hurdles will be addressed over the next 2-5 years.

OVERVIEW OF ERGO TEAMS

Ergo worked with leading experts who specialize in areas related to private equity exits in China. Overall, 14 experts
participated in this study. Some of these experts were already a part of Ergo’s and EMPEA’s respective networks, while
others were recruited specifically for this project. Experts included:

• A Co-Founder and Managing Director of an Asian fund of funds with offices in Beijing and Hong Kong

• A Senior Portfolio Manager directing private equity investments in Asia

• A Founding Partner of a Chinese law firm who was appointed to the China Securities Regulatory Commission
(CSRC) stock issuance approval body

• A Partner at a Chinese law firm based in Beijing who has participated in A-share and H-share listings of state-
owned enterprises, and cross-board listings of private companies

• A respected authority on China’s economic evolution and financial sector development

• A former investment banker and asset manager who writes and speaks regularly on China’s capital markets

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 Methodology
Introduction
INTRODUCTION
By virtue of its sheer size and incredible growth over the last decade, China presents one of the most compelling
destinations for portfolio and direct investment. Restrictions on foreign investment in China’s A-Share (Renminbi-
denominated) equity markets mean that private equity may offer the best pure play on China’s growth for foreign
investors. Global institutional investors will increasingly seek to capture returns from China’s private enterprises.

Heavy private equity flows into China appear to agree with this thesis. EMPEA’s latest data (Q3 2010) show that among
emerging market countries, China attracts the greatest share of private equity fundraising and investment. This looks
likely to continue as private equity penetration in China as of 2009 – defined as annual private equity investment
divided by annual GDP – was at 0.13%, or approximately 40% of the ratios for the United States and India.

Yet for all its promise, private equity as an asset class faces a number of challenges in China, particularly when it
comes to exiting investments and realizing returns. The country’s capital markets remain underdeveloped, lacking the
stability of a robust base of institutional investors, and leaving them inordinately prone to the whims and exuberance
of China’s retail investors.

GPs face numerous uncertainties when it comes to exiting investments via IPO – from concerns over future capi-
tal market developments, to trade-offs between onshore and offshore listings, to opaque regulatory processes.
This study provides an overview of these challenges by leveraging insights from Ergo experts in China, Hong Kong,
Singapore, and the United States.

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1

Capital
Developments
Methodology
CAPITAL MARKET DEVELOPMENTS

Market
EVOLUTION OF THE MARKET
China’s capital markets have evolved tremendously over the last decade, led by the government’s efforts to diversify
sources of medium- and long-term finance for Chinese enterprises away from the state-owned banking sector. The
push to develop additional sources of finance – including a nascent corporate bond market and two equity exchanges
– not only promises a sustainable path for private sector growth but also engenders a more favorable exit environ-
ment for private equity investors.

Traditionally, China’s equity markets – the main boards in Shanghai and Shenzhen – served as conduits for state-
owned enterprises to raise capital and privatize their operations. Within the last decade, however, Beijing has shifted
its focus and established two additional exchanges to catalyze the development of China’s private sector:

• The Small and Medium-sized Enterprise

Market
(SME) Board – launched in 2004 on the Year Companies
Exchange Capitalization
Shenzhen Stock Exchange – provides a Established Listed
(RMB)
direct means for SMEs to raise medium-
and long-term capital. It is a segment of Shanghai Stock Exchange 1990 870 18.47 trillion
the main board in Shenzhen. Shenzhen Main Board 1990 467 4.08 trillion

• ChiNext – launched in October 2009 – is Shenzhen – SME Board 2004 327 1.69 trillion
an independent exchange modeled on the
Shenzhen – ChiNext 2009 130 560 billion
NASDAQ. ChiNext is particularly focused
on high-tech, high-growth startup All data are year-end 2009, except for ChiNext (Oct 2010). Sources: CSRC Annual Report 2009, Zero2IPO
Research Center.
companies.

The creation of these exchanges promises to diversify the sources of Chinese economic growth over the coming
decade. Already, private equity investors have been able to generate substantial returns and exit multiples through
public listings on the SME Board and ChiNext.

PARTICIPATION OF CHINESE INVESTORS – RETAIL & INSTITUTIONAL

Key Facts

At the end of 2009, the China Securities Regulatory Commission (CSRC) disclosed that there were more than 170
million registered securities accounts.

• Securities investment funds held 12.72% of the free-floating shares listed on the Shanghai and Shenzhen
exchanges.

• The 94 Qualified Foreign Institutional Investors (QFIIs) held 1.4% of the free-floating shares listed on the Shanghai
and Shenzhen exchanges.

For both retail and institutional investors, the trend lines are clear: equity investments are increasing across the
board. Chart 1 demonstrates that the number of retail and institutional investors has grown exponentially over the
last decade.

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 CAPITAL MARKET DEVELOPMENTS || PARTICIPATION OF CHINESE INVESTORS - RETAIL & INSTITUTIONAL

Capital
Developments
Methodology
• The number of retail investors – exemplified by the number of securities accounts – grew 3.5x from 1999-2009,

Market
and institutional investors – exemplified by the number of securities funds – grew 34x over the same period.

• At the same time, the size of securities funds has grown by 48.5x. Within these funds, turnover has increased
6.3x, implying that institutional investors may be pursuing a more long-term approach to asset allocation than
their retail counterparts.

CHART 1

The Number of Retail and Institutional Investors in China Grows…

20,000
600
18,000

Number of Securities Investment Funds

Number of Securities Accounts (10,000)

16,000 500
14,000 No. of securities investment funds
(institutional investors) 400
12,000
No. of securities accounts
(retail investors)
10,000
300
8,000

6,000 200

4,000
100
2,000

0 0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Year
Source: CSRC Annual Report 2009. Ergo analysis.

...As Fund Size and Turnover Increase

30,000 14,000

12,000
25,000
Securities investment funds size (left axis)
Securities investment funds turnover (right axis) 10,000
20,000
RMB 100 million

RMB 100 million

8,000
15,000
6,000

10,000
4,000

5,000 2,000

0 0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Year
Source: CSRC Annual Report 2009. Ergo analysis.

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 CAPITAL MARKET DEVELOPMENTS || PARTICIPATION OF CHINESE INVESTORS - RETAIL & INSTITUTIONAL

Capital
Developments
Methodology
Dominance of Retail Investors

Market
Retail investors are estimated to account for 85% of all trading activity on China’s domestic exchanges. This contrasts
sharply with the United States, where retail investors own less than 30% of shares outstanding and represent, on
average, less than 2% of trading volume on the NYSE.

One explanation for the dominance of retail investors is that they have few investment alternatives. One executive
at a fund of funds notes that when it comes to asset allocation for individual investors in China, “it’s either stocks or
real estate.”

Large household holdings of equities are expected to continue over

the next 2-5 years. As one GP based in China notes, China’s capital [China’s capital markets]
markets “will develop very similarly to Taiwan’s but at a much larger
scale.” Taiwan is “still a retail market—they like gambling,” charac-
will develop very similarly
terized by investors “like housewives and taxi drivers that engage to Taiwan’s but at a much
in trading.” larger scale.
The chart below demonstrates that equity assets ownership by - GP based in China
China’s households is forecast to continue on a trajectory of expo-
nential growth.

• Equity ownership by China’s households is estimated to grow from a base of $281 billion in 2005 to $3.8 trillion in
2014, representing an impressive 10-year CAGR of 36%. The $3.8 trillion of equities held by Chinese households
in 2014 constitutes 24% of the value of equities held by U.S. households this year.

• China’s household equity holdings are forecast to be the 2nd largest in the world by 2014 – behind those of the
United States – and are expected to outpace those of other leading emerging market economies (e.g. India and
Brazil), as well as those of leading developed countries (such as Japan and Germany).

CHART 2

Equity Assets Held by the Household Sector

China’s holdings are forecast to be the 2nd largest in the world by 2014.
This value constitutes 24% of the value of equities held by U.S. households in 2010.

4,000,000

3,500,000

3,000,000
10-Year CAGR: 36%
2,500,000
Million USD

2,000,000

1,500,000

1,000,000

500,000

0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Year

India Brazil Singapore Germany Japan China

Source: Economist Intelligence Unit Market Indicators and Forecasts. Ergo analysis.

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 CAPITAL MARKET DEVELOPMENTS || REQUIREMENTS TO IMPROVE QUALITY OF LIQUIDITY

Capital
Developments
Methodology
This dominance by retail investors, notes one GP, leads to “huge waves of irrational exuberance;” such irrational

Market
exuberance was best on display in 2007, when low interest rates and a global search for yield fuelled a speculative
bubble of historic proportions. Cognizant of the continued growth projected in the retail investment sector and its
potential impact on volatility, the Chinese government has made the growth and development of institutional inves-
tors a national priority.

The Rise of Institutional Investors

In addition to the Qualified Foreign Institutional Investor program launched in 2002 – a program that allows licensed
foreign investors to trade A-Shares – the government now allows the National Social Security Fund to invest up to
40% of its assets in equities. Moreover, the government recently amended the National Insurance Law such that
insurance companies can allocate up to 25% of their assets in stocks.

In many ways, developments in China par- CHART 3

allel the history of equity ownership in the
United States. Before the emergence of Holdings of U.S. Equities by Type of Investor
mutual funds and large institutional inves- Roadmap for China?
tors in the United States in the 1960s and 100%
70s, households (retail investors) owned 90%
the majority of U.S. equities. As the chart 80% …as the number of institutional investors increased.
to the right demonstrates, the emergence 70%
of professional asset managers and pen-
60% Households’ share of equity assets decreased…
sion funds led to a steady increase in the
50%
proportion of equities controlled by insti-
40%
tutional investors.
30%
Efforts to develop a sophisticated class of 20%
long-term institutional investors, such as 10%
mutual funds, endowments, and pension 0%
funds, could bring a number of advantages 52 57 962 67 72 77 982 87 92 97 02 007
19 19 1 19 19 19 1 19 19 19 20 2
to China’s equity markets. Long-term, pro- Year
fessional investors could reduce volatility Households Institutions Governments (State and Federal) Rest of the World
and improve corporate governance, while Source: Federal Reserve Statistical Release, Z.1, Flow of Funds Accounts of the United States. Ergo analysis.
providing a ready source of demand for
equities and IPOs.

REQUIREMENTS TO IMPROVE QUALITY OF LIQUIDITY

While continued growth of investors in China portends highly liquid equity markets, investors and industry experts
point to numerous areas for improvement in the quality of liquidity in the Chinese market.

Most observers of Chinese equity markets believe there is a surfeit of retail liquidity, which contributes to speculation
and market volatility. Chinese authorities are very concerned with “hot money” and inflation, so much so that Beijing
recently limited foreigners’ access to the property market, and the government has increased the reserve require-
ment at large banks to 18% (16.5% for smaller banks) in an effort to contract the monetary supply and suppress
Consumer Price Index (CPI) inflation.

While these issues raise concerns over market liquidity in the near-term, private equity and capital market experts
see several opportunities for government intervention to improve both the quantity and quality of liquidity over the
long-term:

• A free floating currency. A move to full convertibility of the Renminbi and an opening of the capital account would
contribute to greater liquidity: it would facilitate the development of institutional investors, critical for stable

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 CAPITAL MARKET DEVELOPMENTS || REQUIREMENTS TO IMPROVE QUALITY OF LIQUIDITY

Capital
Developments
Methodology
long-term liquidity. A class of professional investors could mitigate market volatility. According to Alison Nankivell,

Market
a Beijing-based Senior Portfolio Manager for EMPEA member Export Development Canada, “there’s no systematic
analysis of companies on the part of investment banks. There’s nothing to sustain liquidity.” The entrance of more
foreign participants could create opportunities for the professionalization of China’s institutional investors. With
a free float, China’s state-owned banks and brokerages could shift from serving as political instruments to fidu-
ciaries, and could catalyze a move toward value investing and professional portfolio management. Relieved from
political pressures, Chinese institutional investors could adopt risk-return profiles suitable for their objectives.

Status: Given Beijing’s concerns over CPI inflation and the potential for the second round of quantitative easing to
cascade liquidity on Chinese markets, a move to a free float is not expected within the next 5 years.

• Improving transparency and corporate governance.

The government is emphasizing the need to improve
corporate governance, responsible reporting, and
All the technical people in the
transparency and disclosure within Chinese compa- government know these issues
nies. A key component of this includes the development well; but in the end, it’s the Party
of independent credit ratings agencies. However, in
addition to the increased standards for the private that determines the direction,
sector, several experts note that the Chinese govern- pace and scope of capital mar-
ment itself needs to improve the transparency of its
ket reforms.
legal and regulatory system – to include a legal and
judicial system that fosters trust among investors, and - Pieter Bottelier
develops bankruptcy law and case law (precedents).

Status: Progress toward these goals remains unclear, however Chinese Accounting Standards are gradually being
phased out in favor of International Financial Reporting Standards and U.S. GAAP.

• Increasing the number of quality companies. China’s lofty price-earnings (P/E) ratios are a symptom of too
many Renminbi chasing too few issues. The launch of the SME Board and ChiNext demonstrate the govern-
ment’s commitment to private sector development, and should facilitate the entrance of quality companies to
market. There are currently backlogs of companies wishing to launch IPOs domestically; satisfying the stringent
listing requirements should provide investors with a degree of confidence in the quality of listed companies.

Status: Chinese regulators continue to approve companies for listing on the country’s exchanges. However, experts
note that CSRC may need additional staff to process applications and clear existing backlogs, and advise that
regulatory authorities may halt listings if stock prices appear overheated.

• Legal person share reforms. The Chinese government is calling for all non-tradable shares (legal
person shares) to be made tradable. This reform could triple the size of the market in terms of trad-
able shares, increasing total market capitalization from approximately US $1.2 trillion to US $3.5
trillion. One capital markets expert notes, “downward pressures are building up due to the fact that a vast
number of institutional shareholders wish to cash out.” While this may create headwinds for equity prices
and IPO exit multiples in the near-term, it should provide for a more stable market over the long-term.

Status: Legal person share reforms are on-track to be implemented by the end of 2010.

Actions taken toward each of these reforms could be self-reinforcing and have cascading effects on the market as a
whole. Private equity itself may be a driver of these market improvements. EDC’s Nankivell notes that “private equity
investors – people who want to see successful exits – will probably create more pressure on the regulatory system
to be acting in a more professional way, and that probably will accelerate the pace of professionalization of the key
players.”

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 CAPITAL MARKET DEVELOPMENTS || REQUIREMENTS TO IMPROVE QUALITY OF LIQUIDITY

Capital
Developments
Methodology
The Chinese government is believed to be well-aware of the
Private equity investors – peo-

Market
reforms required to develop stable and liquid capital markets,
however capital markets experts agree that reforms will be
gradual, making a float of the Renminbi unlikely within the
ple who want to see successful
next five years. exits – will probably create more
pressure on the regulatory
Pieter Bottelier, a seasoned observer of China’s financial sec-
tor, captures a prevailing sentiment among Western experts system to be acting in a more
consulted for the study: “Ultimately it’s a political question. professional way.
All the technical people in the government know these issues
- Alison Nankivell
well; but in the end, it’s the Party that determines the direc-
tion, pace and scope of capital market reforms.”

IMPACTS OF AN RMB FLOAT

Most experts agree that a move to a free floating currency – including full convertibility
on the capital account – is not likely to happen within the next five years. The impact of
an RMB float on foreign ownership of A-Shares remains opaque.

• On the one hand, Beijing could retain controls on the capital markets to prevent a
flood of foreign purchases of Chinese equities.

• On the other hand, liberalization of the capital markets could open up opportunities
for Chinese investors to purchase offshore assets; these investment opportunities
are currently limited to Qualified Domestic Institutional Investors (QDIIs). A flood
of capital out of the country could mitigate any asset price increases due to new
foreign interest.

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2

Global
Methodology
Chinese vs.
IPO EXITS: CHINESE VS. GLOBAL EXCHANGES

Exchanges
TRENDS IN LISTINGS
The decision of where to list an IPO lies primarily with the portfolio company, or with the investment bankers under-
writing the transaction. Thus, an examination of the listing trends of Chinese companies should be instructive for GPs
eyeing exits via IPO. The recent opening of the ChiNext exchange and Beijing’s encouragement of local companies to
list domestically are likely to reinforce the trends outlined below.

The listing preferences among Chinese companies are clear: they overwhelmingly prefer to list domestically on the
A-Share market, rather than listing in Hong Kong (H-Shares) or New York (N-Shares, or ADRs). Chart 4 shows the
dominance of A-Share listings while demonstrating the desire among some Chinese companies to list offshore.

• In 2009, there were 10 times as many A-Share listed companies as offshore listed companies.

• For the 11-year period from 1999 to 2009, the number of A-Share companies grew at a CAGR of 6.7%, while the
number of companies listing offshore grew at a CAGR of 13.2%

CHART 4

Listings of Chinese Companies

A-Share listings dominate, yet companies continue to list offshore

1800 200
No. of Onshore listed companies [A-share] (left axis)
1600 180
No. of Onshore listed companies (right axis)

1400 160

Number of Companies (offshore)

Number of Companies (A-Share)

140
1200
120
1000
100
800
80
600
60
400 40
200 20

0 0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Year
Source: CSRC Annual Report 2009. Ergo analysis.

Among offshore listings, Hong Kong is by far the preferred exchange for Chinese companies. Chart 5 provides a break-
down of the exchanges Chinese enterprises have selected for offshore listings since 2005.

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 CHINESE VS. GLOBAL EXCHANGES || PE-BACKED IPOS – VALUATIONS AND EXIT MULTIPLES

Global
Methodology
Chinese vs.
CHART 5

Exchanges
Breakdown of Offshore Listings
Hong Kong is the preferred exchange for most Chinese enterprises
Total Listings

1H 2010 34

2009 57

2008 37
Year

2007 109

2006 78

2005 73

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Proportion of Listings

Hong Kong Main Board Hong Kong Growth Enterprise Market NASDAQ New York Stock Exchange Singapore

Source: Zero2IPO Research Center. Ergo analysis.

PE-BACKED IPOS – VALUATIONS AND EXIT MULTIPLES

The listing preferences of Chinese com- CHART 6

panies gel with those of private equity
investors in China. Rebecca Xu, Co-Founder VC/PE-Backed IPOs (2007-2009)
and Managing Director of Asia Alternatives Private equity investors in China increasingly list IPOs on domestic exchanges
– an Asian Fund of Funds with offices in
Beijing and Hong Kong – and member of 100% 100
EMPEA’s Asia Council, notes “China’s domes- 90% 90
12 22
tic markets will become an important exit 80% 80
Proportion of IPO Activities

Total Number of IPOs

venue in the future.” 70% 70
61
60% 60
50% 50
In the short- and medium-term, notes Xu,
40% 40
the domestic market will be coming up
30% 36 30
from behind. Hong Kong and NASDAQ will 23
20% 33 20
continue to play a very meaningful role for 10% 10
IPO exits, but companies will increasingly 0% 0
choose to list in Shanghai or Shenzhen. 2007 2008 2009
Other offshore exchanges (e.g.Singapore
Domestic IPOs (Proportion of total - left axis)
and London) will play a minor role, and will Overseas IPOs (Proportion of total - left axis)
be targeted mainly by Chinese companies Total IPOs (right axis)
seeking to grow their market share in a spe- Source: Zero2IPO Research Center. Ergo analysis.
cific geography or industry.

The data for VC/PE-backed IPOs bear out Xu’s analysis. Chart 6 shows a clear shift of PE-backed IPOs away from
offshore and toward onshore listings; Chart 7 provides a simple explanation for this shift: exit multiples.

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 CHINESE VS. GLOBAL EXCHANGES || PE-BACKED IPOS – VALUATIONS AND EXIT MULTIPLES

Global
Methodology
Chinese vs.
CHART 7

Exchanges
Average Return on Book Value of VC/PE-backed Chinese IPOs
Valuations on domestic exchanges offer much more favorable exit multiples

25
Q4 ‘09 Q1 ‘10 Q2 ‘10 Q3 ‘10

20

15
Multiple

10

0
Singapore NASDAQ Hong Kong New York Shanghai Shenzhen - Shenzhen -
Main Board Stock Exchange SME Board ChiNext

Offshore Exchanges Domestic Exchanges

Source: Zero2IPO Research Center. Ergo analysis.

While the potential for attractive exit multiples certainly plays a role in the decision on where to list, a number of
benefits of listing offshore also factor in to the calculus, such as access to a broader range of investors and shorter
lockup periods. These are outlined in the text box below.

ADVANTAGES TO LISTING OFFSHORE

• Diverse investors. Access to a broader range of investors so as to diversify the com-

pany’s capital base.

• Prestige. The prestige associated with an international listing can confer an implied
level of trust and corporate governance.

• Avoiding capital controls. Listing in Hong Kong or New York frees up investors to
deploy capital more freely.

• Shorter lockup periods. Sponsors face a lockup period of three years—and investors
a lockup of 12 months—on Chinese exchanges versus a typical lockup of 6 months
for offshore exchanges.

• Ease of listing. The registration and listing requirements in Hong Kong, Singapore,
and the Western bourses are much less stringent than those in Mainland China. This
efficiency is true not only for the IPO, but also for secondary placements and subse-
quent capital raises.

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 CHINESE VS. GLOBAL EXCHANGES || PE-BACKED IPOS – VALUATIONS AND EXIT MULTIPLES

Global
Methodology
Chinese vs.
There is no discernible premium for transparency. While offshore listings demand more rigorous transparency,

Exchanges
accounting, and corporate governance standards, they generally trade at a discount to onshore listings.

Onshore listings may offer potential for outsized returns, but GPs and their portfolio companies will be subjected
to an opaque IPO approval process. While GPs may not drive the decision to list onshore versus offshore, they must
manage the tradeoffs involved, balancing the need to maximize returns while satisfying the needs and objectives of
their LPs.

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3

Methodology
Environment
Regulatory
REGULATORY ENVIRONMENT

THE IPO APPROVAL PROCESS – A BLACK BOX

Private equity investors in China point to the opacity of the regulatory process for IPO approvals as the most vex-
ing aspect of exiting in China – more so than concerns about capital markets development or convertibility of the
Renminbi. Practitioners in China believe that regulators, when given a choice, may approve domestic-owned compa-
nies for listing before foreign-owned companies.

Two notable Chinese legal experts disagree. Bai Yanchun,

a founding partner of King & Wood in Beijing, has worked
with over 150 corporations seeking listing approval, and was At a policy level the Chinese
appointed to the CSRC in 2008 as one of the members of its gover nment is tending to
stock issuance approval body. Bai notes that circulars issued
by the State Council demonstrate that “at a policy level the
encourage investors to list
Chinese government is tending to encourage investors to list domestically…but in reality,
domestically…but in reality, most of the FIEs [Foreign Invested most of the [Foreign Invested
Enterprises] are not enthusiastic about doing domestic
listings.” Enterprises] are not enthu-
siastic about doing domestic
Bai notes that the detailed regulations “do not contain any-
listings.
thing that could be prejudiced against foreign investors.
Regulators are providing equal treatment…but companies - Bai Yanchun
must read the regulations closely…the conditions and stan-
dards at CSRC are harsher here for an IPO in the domestic
market [than in other exchanges such as Hong Kong].”

Yu Yongqiang, a Partner of Jun He Law Offices in Beijing and a specialist in securities transactions, shares Bai’s view
that China encourages foreign companies to launch IPOs in China. He adds that the process can be “quite compli-
cated,” and that CSRC and the National Development and Reform Commission (NDRC) “focus a lot of attention on the
use of the proceeds from the listing.”

However, a partner in a leading international law firm’s office

CSRC is not very willing to in Beijing notes that while the Chinese government is open
to foreign investment in pre-IPO and post-IPO companies in
approve foreign-controlled China, an examination of the details of transactions reveals,
companies in IPOs. These days, “CSRC is not very willing to approve foreign-controlled com-
political issues are key to IPOs… panies in IPOs.” This lawyer adds, “These days, political issues
are key to IPOs. If you have shareholders with certain back-
There’s no sound practice for grounds, that could raise issues…There’s no sound practice for
approval, and there are no clear approval, and there are no clear guidelines for how to interpret
certain rules.”
guidelines for how to interpret
certain rules. Specific factors our experts believe regulators are consider-
- Partner, International law firm’s office in Beijing ing include a company’s ability to demonstrate competency
in a core business, rather than diversified operations (spe-
cifically for ChiNext listings); the absence of material changes
(e.g., to assets, ownership or the business) during the previ-
ous three years; and shareholder continuity and related-party
transactions.

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 REGULATORY ENVIRONMENT || THE IPO APPROVAL PROCESS – A BLACK BOX

Methodology
Environment
Regulatory
One foreign GP based in China adds that political support – at both the local and the national levels – may be vital
to receiving approval. With long waiting lists, this expert believes the bigger, nationally branded domestic companies
and SOEs are moved to the top of the list for approval.

Alison Nankivell agrees with this analysis, adding that

non-strategic companies that don’t have any govern- Until there are transparent
ment involvement may find it difficult to receive approval. criteria – and until they are
“There’s going to be a policy spin to why certain compa-
nies will get favored treatment,” notes Nankivell, “and honored – it will not be possible
until there are transparent criteria – and until they are to have any confidence where
honored – it will not be possible to have any confidence
where you’ll sit in the IPO approval ranking.” Moreover,
you’ll sit in the IPO approval
municipal governments are now getting involved with ranking.
Renminbi-denominated funds, creating another wrinkle
- Alison Nankivell
for foreign-invested companies seeking opportunities to
list on domestic exchanges.

A Chinese expert on the country’s capital markets suggests that while traditional economic stalwarts such as
Guangdong and Shanghai may enjoy some privileges when it comes to listing, the central government is “increasingly
and sharply under pressure to grant more policy favors to the less developed inland regions.” Thus, while the central
government remains the most crucial in the process, local political issues are germane to the approval process.

Typical A-Share Approval Process

Timelines vary on a case-by-case basis, and have been known to exceed two years

• Only a joint stock limited company (JSLC) is qualified as

STEP 1: RESTRUCTURING an issuer and a limited company (LC) shall be altered to
a JSLC
1-3 months

• Improve corporate governance; establish internal control

• Train directors, supervisors, senior management, and 5%
shareholders
STEP 2: COACHING • Special issuers (e.g., banks, securities co.) must obtain
3 months supervisory opinion from regulatory authorities (CSRC,
CBRC)
• Submit Sponsor Letter to CSRC after coaching

• CSRC determines whether to accept the application

within 5 days of filing
• CSRC questions local government and the NDRC, and
STEP 3: FILING & HEARING comments on the application documents; issuer shall
approximately 3 months pre-disclose prospectus within 5 days after responding
to CSRC comments
• Public Offering Review Committee (PORC) hears the
application

• Public offering made within 6 months of obtaining

approval
STEP 4: OFFERING & LISTING • Disclosing prospectus and pricing based on road show
within 6 months • Application to stock exchange for listing
• Sponsor shall continue to monitor issuer for more than
two years after listing
Total: 12-15 months
Source: Partner, Chinese law firm based in Beijing.

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 REGULATORY ENVIRONMENT || LOOKING FORWARD

Methodology
Environment
Regulatory
LOOKING FORWARD
Given Beijing’s increased concerns over frothy property markets and CPI inflation, IPO exits onshore could be a dicey
proposition in the near-term. Several experts note an alarming level of uncertainty in global capital markets, which
could suppress appetites for IPOs on offshore exchanges as well.

One added complication in the near-term is Beijing’s effort to formalize lending. One expert on China’s capital mar-
kets notes that Beijing’s efforts to control interest rates so tightly has fostered a tremendous amount of off-balance
sheet lending via trust products and unofficial financial mediation – at rates a multiple of official interest rates. This
inhibits the development of official institutional investors. To ameliorate this situation, the head of the China Banking
Regulatory Commission, Liu Mingkang, has ordered state banks to get all off-balance sheet items on-balance sheet
by the end of 2011. This is creating additional uncertainties for the equity markets.

Looking ahead 2-5 years, experts anticipate greater stability in the equity markets and ample demand for IPOs.
Over the next two years, China likely will continue its financial sector reforms and create a more favorable environ-
ment for foreign-owned portfolio companies to list on domestic exchanges. The addition of an international bourse
in Shanghai, expected to launch within the next 1-2 years, could contribute to a more favorable IPO environment for
foreign-owned portfolio companies.

Beyond 2012, however, it is unclear whether capital market liberalization will continue. There will be a change in
government during the 18th Party Congress at the end of 2012, and the outcomes of the election could dramatically
affect private equity investors. GPs and LPs alike should begin assessing potential impacts that a shift toward a less
reform-minded government might have on their exit prospects.

Regardless of the timeframe, GPs’ portfolio companies will need to be in full compliance with CSRC’s regulations,
to include the clear identification of uses of proceeds from an IPO. GPs will ultimately need to conduct stakeholder
analyses to ensure their portfolio companies have the support of local governments (through job creation, tax rev-
enues, etc.) and are aligned with national policy priorities. Unfortunately, the latter could be prone to unexpected
shifts, and portfolio companies could become hostage to policy debates.

The competition for listing on China’s exchanges likely will remain stiff, and the increased municipal involvement
in private equity will add complexity for foreign GPs and LPs. Renminbi-denominated funds could have advantages
over their foreign currency peers, and LPs may want to identify GPs likely to have an array of Chinese co-investors.
Ultimately, savvy GPs who have a keen understanding of the local political and economic conditions should be able
to maximize the returns to themselves and the LPs that fund them.

For more information on this or other emerging and frontier markets issues, turn to www.ergo.net 19
4

Methodology
References
REFERENCES
In addition to the experts interviewed for this study, the following secondary resources were
consulted for this project:

Ahn, James and David Cogman. “A quiet revolution in China’s capital markets.” McKinsey on Finance, 2007 (No. 24).

Asia Private Equity Review. “An Illusive Market.” August 2010.

Asian Venture Capital Journal. “Asian Private Equity Barometer.” 3Q 2009.

Bain & Company. Global Private Equity Report 2010.

http://www.bain.com/bainweb/publications/pdf.asp?id=27621

Barboza, David. “Attention Shifts to China for Private Equity Industry.” New York Times, November 20, 2009, accessed October 28,
2010, http://www.nytimes.com/2009/11/20/business/global/20blackstone.html.

China Securities Regulatory Commission (CSRC). Annual Report 2009.

CSRC. Annual Report 2008.

Cookson, Robert. “Shenzhen takes over as China’s listing hub.” Financial Times, October 18, 2010, accessed November 8, 2010.

Deal Journal. “The Go-Go World of Private Equity in China.” Wall Street Journal Online, August 30, 2010, accessed November 10,
2010. http://blogs.wsj.com/deals/2010/08/30/the-go-go-world-of-private-equity-in-china/tab/print/

Deal Journal. “New Rules for Private Equity Investors in China.” Wall Street Journal Online, January 18, 2010, accessed October
28, 2010. http://blogs.wsj.com/deals/2010/01/18/new-rules-for-private-equity-investors-in-china/tab/print/

Deloitte. “Deloitte Survey: 79% of PE investors expect investment activities to rise in China.” Accessed October 28, 2010. http://
www.deloitte.com/view/en_CN/cn/press/cn-pressreleases-en/ee91a30acb9ab210VgnVCM2000001b56f00aRCRD.htm

Deloitte. China: Private Equity Confidence Survey. August 2008.

Economist Intelligence Unit (EIU). Market Indicators and Forecasts database.

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Emerging Markets Private Equity Association (EMPEA). “EMPEA Industry Statistics.” October 2010.

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Ernst & Young. Global IPO trends 2010. http://www.ey.com/Publication/vwLUAssets/EY_Global_IPO_Trends_2010/$FILE/EY_

Global_IPO_Trends_2010.pdf
Evans, Alicia Davis. “A Requiem for the Retail Investor?” Virginia Law Review 1105 (2009).

Huang, Yasheng. “Private ownership: The real source of China’s economic miracle.” McKinsey Quarterly, 2009 (No. 1).
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INSEAD. “Asian Private Equity – Will it Deliver on its Promise?” http://www.insead.edu/facultyresearch/centres/global_private_
equity_initiative/publications/documents/INSEAD_AsiaPEReport_long.pdf

For more information on this or other emerging and frontier markets issues, turn to www.ergo.net 20
 REFERENCES

Methodology
References
INSEAD. “’Leave no stones unturned’: due diligence in China’s private equity market.” Accessed October 28, 2010. http://knowl-
edge.insead.edu/china-private-equity-due-diligence-101015.cfm?vid=470

KPMG. “Beijing clarifies regulatory and tax treatments for locally incorporated private equity funds.” China Alert, February 2009.

KPMG. “Private Equity in China: Market sentiment survey.” September 2008.

KPMG. “The Rise of China’s Capital Markets.” November 2007.

Mayer Brown. “CIRC Permits Insurance Companies to Diversify Their Investments into Private Equity and Real Estate Sectors.”
September 22, 2010. Accessed October 28, 2010. http://www.mayerbrown.com/privateequity/article.asp?id=9679&nid=8641

OECD. OECD Economic Surveys: China. February 2010.

Peaple, Andrew. “China’s Private Equity Finds a New Friend.” Wall Street Journal Online, September 3, 2010, accessed November
10, 2010.
http://online.wsj.com/article/SB10001424052748704206804575468740929354972.html#printMode

Price, Michelle. “China dominates Asian IPO pipeline.” The Banker, September 2010.

Ross, Lester. “Choosing a China Investment Vehicle.” China Business Review. September-October 2010. Accessed October 28,
2010. http://www.chinabusinessreview.com/public/1009/ross.html.

Sheng, Ellen. “China-Focused Private-Equity Firms Look to Stocks.” Wall Street Journal, August 4, 2010, accessed November 10,
2010.

Waldmeir, Patti. “China IPO fears after tepid CNC debut.” Financial Times, January 8, 2010, accessed November 8, 2010.

Waldmeir, Patti. “China regulator criticizes IPO pricing.” Financial Times, February 1, 2010, accessed November 8, 2010.

Waters, Richard. “Valley’s venture capitalists eye Asia for IPOs.” Financial Times, October 27, 2010, accessed October 7, 2010.

Zero2IPO Research Center. “H1’10 Sees 212 Chinese Enterprises Completing IPOs.” Accessed October 28, 2010. http://www.
zero2ipo.com.cn/en/n/2010-8-3/201083144952.shtml.

Zero2IPO Research Center. “113 Chinese Enterprises Totally Offer US$21.83B.” Accessed November 11, 2010. http://www.
zero2ipo.cn/en/n/2008-12-10/2008129163707.shtml

Zero2IPO Research Center. “China Venture Capital & Private Equity Market 2009 Review.” http://www.zero2ipo.com.cn/promo-
tion/ChinaVCPE2009AnnualEN.pdf

Zero2IPO Research Center. “China Venture Capital & Private Equity Market amid Recovery from Financial Crisis: Statistic Review
of 2009.” http://www.zero2ipo.com.cn/promotion/CVCF-2009-Annual-12-09-EN.pdf

Zhang, Gillian. “Z-Insight: The First Anniversary of ChiNext – Fever Cooling Down.” Accessed November 12, 2010. http://www.
pedaily.cn/Item/200263.aspx

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 Methodology
About Ergo
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ABOUT THE AUTHOR

Michael Casey is a Research Manager in Ergo’s Washington, DC office. You may contact him via e-mail at mcasey@
ergo.net.

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