China private equity in transition
Strong industry growth over past decade; Adverse effect of dearth of IPOs
China’s private equity industry has been going through a long-term growth spurt, with the number of private equity firms growing three-fold over the past decade to number more than 750 today.
However, the industry is at a transitional stage as a result of the virtual closure of the Chinese IPO market in recent months.
According to a China Scope Financial report, recent data from the China Securities Regulatory Commission show that 761 companies have filed and are currently waiting to go public. As a result, PE fundraising in China has decreased.
Chris Lerner of Eaton Partners, which opened an office in Shanghai in 2007, says: "Private equity in a developing market like China, although less liquid, is not unlike other asset classes. You tend to have more exaggerated swings in sentiment and capital as things evolve; I don’t think private equity is any different in that regard."
He says there are other factors affecting the market, including "structural financing imbalances, policy-driven directives, liquidity constraints, and relatively immature capital markets".
Bob Partridge, head of Ernst & Young’s Greater China private equity practice, says: "Over the last five to eight years, China has gone from an emerging private equity market to a maturing private equity market."
For investors and the industry, there is a need to clearly delineate between long-term investing and short-term speculation. Kwek Ping Yong, chief executive of Inventis Investment Holdings, and author of the books, Private equity in China: Challenges and opportunities and Due diligence in China: Beyond the checklists, says: "PE should not be dependent solely on IPOs for exit. In China, the biggest problem with linking PE with IPOs is that so many pre-IPO funds call themselves PE funds but they are not. Pre-IPO funds are a type of speculative investment." Lerner also talks about the need for increased appreciation of the private equity asset class. He says: "Onshore [in China], I do think some structural things need to change, and this relates both to investor expectations and the mindset of certain GPs [general partners]. A better appreciation and understanding of the private equity investment model is needed and the fiduciary responsibility that goes along with that."
He adds: "Private equity is quietly but increasingly becoming recognized as an important tool in the market overall. With the newly issued view for the way forward coming out of Beijing, I wouldn’t be surprised if there wasn’t an increasing open-mindedness and willingness of the industry and government for private equity to play a greater role in the transformation of the economy."
In future it will not be as easy for private equity firms to make passive investments in companies and let macroeconomic factors and a rising economy drive the return.
Lerner says: "To build a long-term business as opposed to just raise a fund, I think, is the next phase of private equity." He also notes that entry valuations and underwriting assumptions are a way to better assess the likelihood for consistency of performance in a dynamic environment.
Without the possibility for IPOs, Yong talked about other exit options for PE funds such as trade sales and selling investments.
With the industry evolving, successful PE firms will need demonstrable institutional investment processes. The importance and comprehensiveness of the limited partner due diligence process will increase and more attention will be paid to GPs’ risk controls, operational capabilities, and corporate governance.
Lerner says: "Given the uncertainty in the current environment and the heightened level of scrutiny from investors, where we’ll see demand in a market like this is from ‘right sized’ funds that are focused and have differentiated strategies investing a manageable amount of money with a clear, repeatable investment process. The challenge is that the investment landscape keeps evolving, new managers keep spinning off and fund sizes of the established managers keep growing, so it is challenging to find and properly assess track records."
Yong also talks about the need for a disciplined investment process. He says: "There is a need for a strong deal-sourcing ability and due diligence ability to find the right target company".
A less-liquid IPO market will lead to longer holding periods and lower return expectations. In China, particularly on the retail side, investors tend to be more opportunistic in nature. Talking about domestic, high-net-worth investors, Lerner says: "They were drawn to the pre-IPO market and quick return. Return expectations were aggressive and funds were structured with short durations."
Lerner thinks there is the possibility of this capital being allocated to other investments, but also acknowledges domestic investors have limited options and have to wait for distributions to come back from private equity investments. He says: "Traditionally, most private capital would go into real estate as a store of value because onshore money doesn’t have a lot of places to go. For those now invested in private equity funds, the money has to first come back." He expects to "see a greater diversity of strategies and product."
Yong points to upside potential due to possible regulatory changes: "If the Chinese government loosens regulations, that will open up a lot more sectors to look at [to invest in]."
Lerner acknowledges the industry faces challenges, but is bullish about the long term. "Broadly speaking, the trend offshore is a gradually increasing allocation to Asia and China is a large part of that."