HONG KONG, Oct 21 (Reuters) - A dramatic fall in the value of Morgan Stanley's Asian private equity funds hit the bank's quarterly earnings, highlighting the risks of such investing at a time when rivals are scaling back to avoid losses and higher regulatory costs.
Morgan Stanley's investment portfolio suffered a $235 million loss during the July-September period, compared with a profit of $232 million in the previous quarter, Morgan Stanley CFO Jonathan Pruzan told analysts.
"Virtually all of that negative number can be attributed to the reversal of carry from our Asia PE business," Pruzan said.
Private equity firms make a standard 2 percent fee based on the assets they manage, and can earn additional 'carry', or share of the profits, on beating certain pre-determined performance goals.
Having performed strongly amid China's booming markets earlier this year, the funds saw that reverse amid China's stock market mayhem this summer, which at one point wiped out more than $3 trillion of investor wealth.
Morgan Stanley's Asia buyout funds manage more than $4.5 billion largely in Chinese and South Korean companies.
The funds are also stuck with at least three large stocks which have not traded for several months, making it harder for them to accurately value their portfolios or exit.
Those include Tianhe Chemicals Group, whose shares remain suspended following criticism by a short-selling research company. The Morgan Stanley private equity unit invested $300 million for a minority stake in Tianhe in 2012, its biggest equity investment in Asia.
Last year, research group Anonymous Analytics accused Tianhe of overstating profits in its initial public offering prospectus ahead of its Hong Kong listing.
Another stock in its portfolio, China Shanshui Cement Group , has been suspended since April after its free float dropped below the regulatory requirement.
Voluntary trading suspensions are common among Chinese companies. During the market turmoil this summer, more than half the Shanghai-listed companies halted their shares at one point.
In such situations, private equity firms use the closest proxy to value their portfolios, including using earnings multiples applied to similar publicly listed companies.
Morgan Stanley's dedicated Asia Private Equity fund strategy is at odds with some of the bank's rivals, which are spinning off buyout arms due to the Volcker rule.
The U.S. rule was put in place after the global financial crisis and caps banks' involvement in risky businesses such as hedge funds and private equity to just 3 percent of Tier 1 regulatory capital.
In Asia, private equity is a growing business.
"It's a long-term business and people are unlikely to change strategy just based on one quarter's volatility. When you are investing in China, public market exposure comes with the turf and one can't escape it," said Vinit Bhatia, partner at Bain & Co's private equity practice in Asia.
"We expect China buyouts to gain momentum over the next five years which will make it even more attractive for private equity firms."
Every publicly listed stock in the Morgan Stanley portfolio lost money in the July-September quarter, with the biggest plungers being a 50 percent fall in Shanghai-listed polyester filament maker TongKun Group Co Ltd, followed by a 28 percent slide in luxury brand distributor Sparkle Roll Group Ltd.
While the China market has stabilised somewhat, Morgan Stanley executives declined to comment on the potential of the funds' performance to recover.
"I'm not going to comment on where that carry will go, going forward. It's obviously going to be based on the investment performance and the valuations in the market," Pruzan added.
The firm's third Asian private equity fund, which raised $1.5 billion in 2007, accounts for the majority of the loss. Morgan Stanley's contribution of its own funds dropped to $50 million from $400 million, reflecting the global reduction in investment banks putting their own money at risk. (Additional reporting by Olivia Oran; Editing by Carmel Crimmins and Phil Berlowitz)