Global private equity today is sailing a course through troubled waters. Though a quick glance at data will show strong investor appetite driven by continued superiority in long-term returns, success for VC (especially in China), and record AUM for global private equity funds, a more granular view exposes some cracks in the armour.
The major developed markets – the USA and Europe – are suffering from disruption and uncertainty that to most this time last year would have seemed unlikely at best. On a global scale investors are concerned about entry valuations, the ability of their managers to source and maintain quality deal flow, the realistic prospects of seeing cheques from highly-valued portfolios, and ever-present questions around terms and conditions, fees, succession and co-investment rights remain topics for discussion.
China in many ways is no exception to these themes but the story continues to be one of success for the top GPs. True to type, Chinese private equity is outperforming the macroeconomic story on a microeconomic scale. Consensus is that China avoided the ‘hard landing’ that many predicted in the last 12 – 18 months and that while levels of debt and leverage, and the NPL situation, remain concerning for some, the fundamentals and sheer scale of China ensure that an attractive opportunity for investment remains for those willing to grasp it.
If that serves as a brief summary of the ‘pull’ factors, let us now quickly examine the ‘push’ – the aforementioned uncertainty caused by Brexit (and worries of the further disintegration of European co-operation and community), and the election of Donald Trump are causing concern for those with heavy portfolio exposure to the USA and Europe.
LPs are having to re-evaluate their perceptions of risk/return profiles in order to satisfy investment committees and in some cases, to fulfil future liabilities. In broad terms, these factors provide impetuous for LPs to broaden their exposure to emerging markets in the search for outsized returns, and China has a compelling case to be seen as the best provider of opportunity in this quest.
The key questions that China GPs need to be answering to their investors start with the issue of money supply for the asset class. China has often been perceived as an overfunded market for private equity, and the explosion of RMB-denominated fund managers in recent times has done nothing to counteract this view. In fact, determining the true size of the market has seldom been more difficult as semi-institutional fund managers, wealth management and crowdfunding platforms, along with state-controlled and owned funds, increase their interest in private equity.
The distortive effect this has on an overview of the market feeds into another key concern – as touched on earlier, investors want to be sure that fund managers can effectively deploy the capital they are raising. There is a lot of dry powder waiting to be put to work in China, but the worry that this is concentrated in a small number of large funds – will the dealflow be there for these managers? At the larger end of the scale it is also highly competitive – is there too much money chasing too few deals?
Sector-wise, the most attractive areas of the economy remain those that best serve the demographic and socio-economic development of China. Healthcare and education remain specialist fields that can outperform considerably if managers have the contacts and expertise to access the right opportunities. Speaking more broadly, the emergence of an urbanising, young professional class is creating opportunity for tech to further integrate itself into everyday life. Retail, particularly high-end, is recovering – aided by technological innovation and disruption across the supply and production chain. The energy sector is also changing as increased international scrutiny of the Chinese economy comes into force, and the government seeks to reduce reliance on imported fossil fuels.
The evolution of the corporate world is also encouraging for private equity. Increasingly, founders are seeing the immediate and long term value of accepting a fund taking a significant or even controlling stake in their company. In an IPO environment that remains difficult, founders increasingly look at the possibility of buyout private equity as an exit route for them as they near the end of their careers. While private equity and the corporate world still has a lot to work on – not least the alignment of event and liquidity horizons – it is clear that the Chinese corporate world is waking up more and more to what private equity can offer them.
Indeed, this extends to the global ambitions of Chinese companies and by extension, Chinese private equity. China’s integration into the international economy is ongoing and while questions remain about the international experience of Chinese corporations, if a GP partner is picked who can execute in foreign jurisdictions, then private equity can doubtless contribute to and profit from this expansionist trend.
Ultimately, concerns still remain about China. Non-Chinese investors will always struggle to a greater or lesser extent with language and cultural barriers and the simple fact of distance from the majority of the Western LP base will never be resolved. However, what can be said now is that factors of political, economic and investment risk are no longer unique to the world’s most populous country.
More so than ever before in 2017, China straddles the gap between developed and emerging markets. While investor concerns can never be fully discounted, China stands poised to take advantage of the global situation and can viably present an opportunity to secure the returns that LPs need to justify a private equity fund commitment in 2017.