The Chinese economy has enjoyed a year of robust economic growth. The run up in commodity prices boosted nominal GDP growth to near decade highs, drove down non-performing loans, and boosted industrial profits. This had the nice benefit of sustaining high levels of consumer spending and helped retail facing businesses from online to restaurants.
There are, however, concerns about the status of the economy and investment outlook going forward. First, commodity prices driven up primarily by inflows into the broadly defined shadow banking sector are now suffering from the sectoral squeeze on asset growth. Most commodity inputs hover around flat from one year earlier and show distinct signs of weakness projecting forward. Given the impact to the broader economy of the nominal inflation, expecting to see nominal GDP growth slow by 1.5-2% in 2018, how will this impact key sectors of the economy?
Second, consumer spending in China has been heavily aided by rapid growth in household debt. While undeniably a significant portion of the debt has been pushed into real estate, the impact on retail has not been immaterial. What is concerning is that by some measures, household debt to household income now tops many developed markets. Consumer debt, consumption, and investment will be hard pressed to continue growing at the rates of the last 12-36 months.
Third, as China is seeking to move into a different economic stage targeting high tech, service, and consumption growth drivers, they have allocated enormous sums of state linked capital into targeted investment. State owned and linked investment funds have nearly $1 trillion USD of AUM pouring into a range of advanced sectors from AI, robotics, to logistics, and health services or products. This is impacting valuations rapidly pushing them up but also accompanying risk and expected future returns on frequently flimsy fundamentals.
A framework for investors
This framework lays out what I see as some of the fundamentals for how investors should be viewing the Chinese private equity (PE) and venture capital (VC) market place.
PE and VC investors in China need to understand the pricing pressure and the investment strategy. With tech VC being dominated by the BAT’s and state linked investment funds, foreign and non-major Chinese funds are going to struggle to compete and target the next hot start up. Where do you fit within the investment structure and what is your exit strategy?
If you are focused more on traditional PE, turnarounds, special situations, in more standard industries lacking the tech growth component, you need to more closely consider the non-financial risks you are incurring. Whether it is distressed debt purchases, industry restructuring, or pre-IPO retail plays, the level of non-financial risks continue to increase. We have witnessed a rapid re-centralization in a variety of key industries specifically industry preventing badly needed downsizing and efficiency gains. Secondary market debt, turnaround, and special situations are increasingly ham strung in broad financial crack down that is sweeping up market focused measures.
Think about your value outside of investment capital. In an overheated, politicized environment what is your competitive edge that is going to help you land deals and earn returns with economic and financial risks on the horizon? Portfolio companies who can choose who they want to work with are looking for more than investment capital but what are the intangibles you bring to the table. Be prepared for what type of deals you want, the risk you are willing to incur and how you can sell your firm as the right capital partner beyond the dollars and cents.
There are enormous growth stories but enormous risks and constant change, both financially and non-financially. You need to have a strategy that helps you pick the deals that match your appetite and manage the risks you accept.