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Web> Business> Finance
UPDATED: December-18-2006 NO.45 NOV.9, 2006
Private Equity Funds Exposed!
Fund secrets may be in jeopardy after government intervention, but this could still be the best time to invest

Private equity funds can be mysteriously operated and they're often an insider's game. As funds that pool large investor contributions to create capital from tens of millions to several billion yuan, they're big business players only getting bigger in cities like Shanghai and Shenzhen. But so far, they don't have to disclose what they do, like public companies, and they're often guided-even invested by-industry insiders.

But with the government seeking to "expose" these funds through new legislation, the countdown to bringing these private equity funds under the spotlight has begun. According to one source, legislation that would reign these funds in is on the agenda of certain government departments.

Those with the most thorough understanding of this often hidden market, even as it begins to open up, should stand to profit the most. Here's a blueprint to success in this emerging market.

Big gains

"From April through to the end of August, our gains have been close to 60 percent," said Jiang, a private equity fund operator in Shanghai who requested anonymity. Jiang is an alias.

In Shanghai, private equity fund investors such as Jiang are not hard to find.

"As far as I know, there are now a large number of private equity funds in Shanghai with capital of 50 million yuan or more," said Jiang. "Private equity funds worth hundreds of million are also commonplace."

The largest private equity fund in Shenzhen currently manages 5 billion yuan in capital, which is equal to that of a medium-sized public fund.

Meanwhile, after this year's Spring Festival, the stock market turned bullish after a long bear market. Private equity funds seized the opportunity and recorded dramatic growth. Such funds have garnered interest and investment funds from many experienced stock market investors.

Jiang used to be a certified analyst at a securities investment consultancy. In April this year, he resigned and began to invest in private equity funds. "I started late. The private equity funds that have been operating for a few years have developed surprisingly fast this year," said Jiang, expressing his regret at his tardiness in beginning his "new enterprise."

According to estimates from the Institute of Finance and Trade Economics of the Chinese Academy of Social Sciences (CASS), the total of all private equity funds currently operating in China's A-share markets has reached 500 billion yuan. According to Wang Guogang, Deputy Director of the Institute of Finance and Banking under CASS, the number is even bigger. He estimates that the total domestic private equity fund has already reached between 800 and 900 billion yuan.

Given this volume, the impact of private equity funds on the markets cannot be ignored. But the effect that these rapidly growing private equity funds is having on the securities markets is at odds with their legal status, which is why the calls for legislation covering private equity funds are getting louder and louder.

Demystifying the mysterious

So how do private equity funds serve their clients? Potential clients can join private equity funds in two ways, both of which provide percentage-based returns.

The first way is "control from behind the curtain," which essentially allows investors to trade themselves under the direction of the private equity fund operator. Newcomers generally adopt this "exploratory" method. According to Jiang, this method rarely achieves good results due to the fact that clients tend to trust their own, more novice judgment, rather than the judgment of the fund manager. And the flow of transactions tends to be interrupted.

The second way is total entrustment to the fund operator. The clients take a back-seat while the fund trades on their behalf.

Private equity funds do not have a minimum investment requirement. But Jiang said that large capital amounts receive different "treatment" compared to small capital investments. For example, transaction frequency might be lower for small capital clients. For large capital clients, on the other hand, private equity funds will help them to optimize their investment portfolios in addition to providing the standard services.

"For clients with capital of over 300,000 yuan, we generally create an investment portfolio," said Jiang. Investment portfolios refer to an arrangement of short-, medium- and long-term investments.

The private equity fund that Jiang operates is not large, so capital of over 300,000 yuan is considered to be a large investment.

In this investment portfolio: A short-term operation can last for one or two days; a medium-term operation can last from a few months to half a year; and a long-term operation can last from one to two years. Each operation comprises a selection of good stocks that are bought and held for the period.

In an investment portfolio, a combination of long-term and short-term investments helps to reduce the turnover rate. Generally speaking, an investment turnover rate of twice per month is considered large. "For large investments, especially millions of yuan, our ideal annual average return is 30 percent-including the bearish periods," said Jiang.

Jiang is very confident of his operational ability, and in his view, a good private equity fund operator is more capable than a public fund operator. In fact, the fund that Jiang manages has only recorded a few temporary downturns, even during periods of market consolidation. "Here is my optimistic prediction: We are going to continue to see a bullish market in the coming six years," Jiang said.

Being "private"

For a long time now, private equity funds have been operating outside the legal market framework. Therefore there are significant legal risks that need to be taken into consideration. In addition, private equity fund investment operations are not public and the commitments provided to clients and the way they operate continues to be something of a mystery to the public. But often the unique characteristics of private equity funds are what make them strong.

"We hope that there will be legislation that will clarify our legal status, but, in terms of disclosure, there should be differences," said Jiang. Private equity funds can only maintain their advantages as long as their positions and investment direction remain non-transparent. According to him, the key difference between public funds and private equity funds is in regard to transparency, not only in terms of legal status, but also in terms of disclosure.

Public funds must release financial statements to the public each quarter, stating their positions on every investment. Private equity funds are not subject to this requirement.

"We need this information to remain undisclosed in order to continue to operate," said Lin, another private equity fund investor in Shanghai who wished to remain anonymous. "Lin" also is an alias.

Sharing returns

Public funds only charge investors for management fees and registration fees, and these fees tend to be relatively low. Private equity funds, however, make their profit by sharing the returns with clients-even as much as 50 percent in some cases (although 20 percent is more frequently the case). Private equity fund operators believe that this profit sharing method serves as motivation to operate in as efficient a manner as possible.

"To us, the biggest pressure is not from the market, but from clients," said Jiang. "Some clients check their account balances frequently and if they are unhappy with the returns, they will complain," he added. But he added that constant communication between clients and fund operators provides good motivation.

He explained: Generally public funds are owned by the public, investors are not specified and the fund operator's responsibilities are not clearly defined. With private equity funds, however, each capital injection is from a specific client who can check their investment status at any time and can give direct feedback to their broker if they are unhappy. This direct connection and the profit sharing method ensure that private equity funds work in an efficient manner.

Choosing fund managers

According to Jiang, private equity fund operators are generally big stock investors. They tend to be long-term players in the Chinese stock markets and have a thorough understanding of the market. They know which shares can make good short-term or medium-term investments. There are times when they also predict the long-term trends of the market. Jiang himself is one of those who have been investing in the securities industry for many years.

Because of this, Jiang believes that fund managers who are overseas returnees or who have a background in industry research do not necessarily have the correct view of the market, making it hard for them to survive in the private equity fund field.

Lin's experience seems to support Jiang's viewpoint. Before investing in private equity funds, Lin had been investing in the stock market for many years. Back then, he had a small private equity operation, with capital of around 1 million yuan, mostly collected from relatives and friends.

During that period, Lin realized that his sense of the stock markets was more sensitive than that of fund managers.

"Early last year, I selected Nanning Sugar, which turned out to be a stock chosen later by the QFIIs (Qualified Foreign Institutional Investors). Back then, the funds weren't paying attention to this kind of share," he recalled proudly.

(Xinhua Finance)

DISCLAIMER: The information contained herein is based on sources we believe to be reliable, is provided for informational purposes only, and no representation is made that it is accurate or complete. This briefing should not be construed as legal, tax, investment, financial or other advice, and is not a recommendation, offer or solicitation to buy or sell any securities whatsoever.

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