China: the glass half full view

The prevailing view, at least in the West, is that China has rather lost its shine lately as far as investors are concerned.

It's easy to see why this might be the case. Particularly for investors outside the region, the myriad headlines in the international press about slowing growth and structural economic weakness are bound to prompt some nervousness. And that’s before you even get to the private equity-specific challenges: regulation, due diligence, exerting influence in minority deals, and, in particular, the slowdown in exits courtesy of the IPO freeze (exit volumes in 2013 were about two-thirds down on 2010, according to Bain & Company).

Fewer exits have meant fewer distributions to LPs; and while distributions have been strong elsewhere, it would be a brave move to switch allocations into Asia right now. So it would hardly be surprising to see an impact on the general appetite for new funds in China – and, by extension, on the mood of the local industry as a whole.

At the HKVCA’s 13th China Private Equity Summit in Hong Kong today, where local practitioners have been offering their take on the Chinese market, it’s true that the bullishness that has often been in evidence in previous years was nowhere to be seen. Indeed, the majority of GPs acknowledged how much more difficult it has become to make good returns in China: that there’s an over-supply and a lack of quality in many sectors; that exits will continue to be tough; and that finding good management talent has become if anything an even bigger challenge.

But it wasn’t all bad news. In fact, glass half-full types might even argue that some of the changes happening in the market at the moment will actually be good for private equity in the longer term.

To take one obvious example: if an entrepreneur has a company that’s growing at 30 percent per year, it’s not easy to convince them that private equity investment can add a lot of value. When growth stagnates, and the issue becomes how to gain market share from competitors – a different sort of challenge altogether – the case for bringing in third-party capital and expertise becomes a lot stronger.

In some cases, entrepreneurs are more willing to cash in and sell out, particularly while the IPO markets are frozen – which means buyouts are becoming possible. And even if the entrepreneur wants to hold onto a majority stake, they’re going to be a lot more willing to listen to advice from their minority partners. As a result, those firms with an operationally-focused strategy, who work actively with their portfolio companies and aim to generate alpha through revenue growth, will increasingly come to the fore. That’s particularly true with companies that are looking to expand out of China, a skill-set they may not have internally.

(An interesting question is whether these trends work to the advantage of the big global funds who have recently been raising capital in the region. On the face of it, this seems plausible; but as the local GPs pointed out today, so much depends on finding the right management, with an understanding of the local Chinese market, and if anything the global firms are currently at a slight disadvantage there.)

Equally, despite all the negative sentiment towards China, it’s worth remembering that a lot of big China-focused funds did get raised last year – and according to local agents, fundraising has been pretty strong this year too.

That’s partly a function of calibre: many of the success stories have been well-established institutions that have outperformed the broader market (which is obviously distorted by the long tail of obscure Chinese funds that won’t even appear on the radar of foreign investors) and continued to return capital, hence why LPs have been re-upping. What we’ve seen in the last couple of years in Asia is a flight to quality, with the bigger funds taking a bigger share of the capital. And as this maturing market starts to reward those firms with a more hands-on approach, that’s likely to continue.