HONG KONG, July 11 (Reuters) – Profits from China's private equity deals have fallen since 2007, a new industry report says, leading to a sharp decline in funds for small and mid-size companies in the world's second largest economy.

China's private equity industry emerged later than its North American and European peers, but has become a vital source of growth capital for the country's smaller companies, which struggle to get regular bank loans.

Private equity capital has fuelled companies such as Alibaba Group, 360Buy and Tudou Holdings , and the prospect of strong returns attracted investors to commit $124 billion to China in the last 10 years, says Asia Private Equity Review, which produced the report.

Close to $100 billion of that money is already invested, but the decline in profits from deals began in 2007, as competition intensified. The fall in profits is a major cause of a sharp drop in fundraising over the past year, say industry executives.

“A lot of private-equity firms generated extraordinary returns, and this attracted many new general partners into the fray between 2007 and 2009,” said Jonathan Zhu, a managing director at Bain Capital, in a July McKinsey report.

The APER data shows a drop in the internal rate of return (IRR), a measure of profitability, from a high of 38.2 percent in 2005 to a low of 4.2 percent in 2010, the last reported date.

A freeze on China IPOs – the main exit route for China private equity investors – is fuelling the problem, leaving many firms unable to return profits to investors, and unable to raise new funds.

Funds raised for China private equity fell 53 percent between 2011 and 2012 to $23 billion, according to Asian Venture Capital Journal.

But as credit tightens, private equity officials with capital to deploy see growing opportunities.

“It's a fantastic time for the industry,” said Derek Sulger, founding partner at China-focused buyout firm Lunar Capital, speaking at the Hong Kong Venture Capital Association conference in Hong Kong last month. “We're going to look back at the next one to three years as a golden period in transactions.”