China Tells

(WSJ) Foreign firms that include some of the biggest names in U.S. private equity are rushing to raise Chinese funds that offer a new route to getting deals done in the world’s fastest-expanding major economy.

In the latest example, Carlyle Group LLC is in advanced discussions to raise a local-currency private-equity fund of several billion yuan, according to people familiar with the situation, after already setting up a previously undisclosed smaller yuan fund earlier this year for growth-capital investments. Kohlberg Kravis Roberts & Co. also is actively studying setting up a yuan-denominated fund, according to people familiar with the situation.

In recent days, other foreign private-equity firms and banks, including Blackstone Group LP and Macquarie Group Ltd., have announced plans to raise a total of about $4.5 billion in funds from local investors.

The allure of the Chinese market is powerful for U.S. private-equity firms that have watched dozens of leveraged buyout deals sour over the past year amid turmoil in credit markets and a global recession. By contrast, China’s economy is emerging from the global financial crisis in better shape than many had expected, expanding 7.9% in the second quarter.

Most deals in China are about $100 million in size and involve little or no leverage. By riding China’s increasing consumer demand and helping Chinese companies navigate an overseas listing, private-equity firms can earn big returns without loading up a company’s balance sheet with debt.

China also offers a huge untapped investor base. That includes the country’s social-security fund, but also a number of wealthy Chinese entrepreneurs, many of whom made fortunes by selling stakes to private-equity firms and listing their companies.

“There is a lot of pent-up demand in China for deploying capital into alternative assets,” said David Liu, KKR’s head of Greater China. “There’s no question that in the longer term the yuan-fund industry is an important initiative for China.”

Foreign private-equity firms have been operating in China for years, but many have struggled to get deals done amid resistance to letting foreigners control prominent local companies.

What has changed is that the foreign firms are setting up funds geared toward local investors holding China’s currency, the yuan. That means domestic investors can share in the profits. The foreign firms, meanwhile, hope they will be treated like domestic investors and free to invest in a broader range of industries.

“Foreign managers will be actively involved in developing the yuan-fund industry,” said X.D. Yang, co-head of Carlyle Asia’s buyout fund. “We’ve been working closely with government agencies on this for over a year.”

The flurry of announcements reflects a sense of urgency among the foreign firms.

“Private-equity firms are worried that if they don’t set up local entities now, they could be at a competitive disadvantage,” said Lawrence Sussman, head of law firm O’Melveny & Myers LLP’s Beijing office. Mr. Sussman expects that the number of yuan-denominated funds in China with foreign participation will more than double this year to about 100 such funds.

Shanghai’s government sparked the recent fund announcements when it released rules in June on establishing funds. It also has been pushing to attract foreign money managers in support of the city’s goal to become an international financial center.

But Shanghai isn’t alone. Beijing, the eastern coastal city of Suzhou and western China’s Chongqing all hope to become private-equity hubs. All are playing catch-up to the northeastern port city of Tianjin, which took the lead in creating rules for private-equity funds and is home to several prominent Chinese funds.

For the foreign fund firms, some hurdles to tapping the Chinese market have been removed, but others remain.

Private-equity firms have to keep their global investors, known as limited partners, happy as they raise money in China. Dividing deals between the foreign and local funds can be tricky and create conflict between the two investor bases, both of which are eager to access the best deals.

And the rules of the game for raising funds in China still aren’t clear, though draft rules governing yuan private-equity funds are in the hands of China’s cabinet, according to people familiar with the situation. Those rules could resolve issues such as approval procedures and the scope of permitted investments.

Foreign money managers have an advantage in raising money because their investment teams have longer track records than local institutions, which have faced restrictions on raising funds in the past. Chinese officials stopped local securities firms from doing private-equity deals in 2001 after securities firms stuffed their balance sheets with deals that soured, forcing a government bailout. In 2007, that ban was lifted for top-tier securities firms, creating more competition.