Chinese private equity managers could face an uncertain future with US public pension funds as tensions between the two nations escalate.

Relations have fallen to their lowest point in nearly 50 years, Cui Tiankai, Beijing’s ambassador to Washington, told NBC News on 4 August. It follows tit-for-tat closures of their respective consulates in Houston and Chengdu, a trade war and increasingly provocative rhetoric from US Secretary of State Mike Pompeo.

The situation has prompted concerns in Asia that US public pensions – some of the biggest investors in private equity globally – will face government and public pressure to reduce their exposure or allocations to Chinese private equity funds.

This dynamic is already playing out in public markets: president Trump ordered the Federal Retirement Thrift Investment Board, a US government agency that manages $594 billion, to halt plans to back an index containing Chinese stocks in May over national security concerns.

“I have heard specific comments relating to concerns on the US-China relationships and geopolitics in general, including stating that their deployment to China might reduce or stop for a little while, at least until there is more clarity for the future,” Vince Ng, a Hong Kong-based partner at placement agent Atlantic-Pacific Capital, told Private Equity International.

Capital has been flowing to China-focused funds raised by domestic GPs, including those headquartered in Hong Kong. They raised $25.5 billion last year across 34 vehicles, more than double the $11 billion raised across 35 funds in 2018, according to PEI data.

Although it’s tricky to get a sense of the scale of US public pension activity in China, PEI data show these institutions have an appetite for managers in the region.

Hong Kong-headquartered Boyu Capital and Beijing’s Primavera Capital, DCP Capital and Centurium Capital, which raised four of the five-largest China-based funds last year, between them collected at least $540 million from five US public plans. New York State Teachers’ Retirement System was particularly bullish, committing $100 million to each of the $3.4 billion Primavera Capital Fund III and $2.5 billion DCP Capital Partners I.

Such firms have raised $4 billion across nine closes so far this year. The largest of these was CDH USD Fund VI, which held its final close on $1.5 billion and included a $25 million commitment from New York State Common Retirement Fund, a public pension.

Still, some of those in market with USD funds or planning a return are expecting an uphill battle in securing commitments from these institutions.

“We’re sensing that US public pensions can be influenced and may have a different strategy towards China down the road,” the managing partner of a China-headquartered venture capital firm told PEI on condition of anonymity.

A number of US pensions have been active in Asia. Christopher Ailman, chief investment officer at the California State Teachers’ Retirement System told PEI in 2018 that the US’s second-largest pension fund could double or triple its exposure to Asia over the following three to five years. Teacher Retirement System of Texas has been mulling a Singapore office as it looks to strengthen relationships in the region.

“Investors that have already come to China have a certain level of comfort and are very bullish,” said a managing partner at a China-focused private equity firm. “People who are interested in getting their toes wet but have very little exposure to China are more hesitant.”

Unfounded concerns?

To what extent US public pension plans will react to geopolitical tensions – if at all – will become clearer in the months ahead.

“On the surface, the current geopolitical skirmish between the US and China will most likely have a negative impact on the appetite of LPs who may already be wary of entering the market,” said Kevin O’Donnell, partner and global head of investor relations at fund of funds manager Adams Street Partners.

“Time will tell if there is any form of divestment, but we have not seen this yet, and would be hesitant to make any predictions around this. Every US public plan has their own set of governance laws and guidelines which dictate the terms and conditions of their overall investment mandate – as such, we would expect every LP’s appetite for China PE to react uniquely as the political climate evolves.”

Fears that public pensions will come under pressure from their beneficiaries may be unfounded.

“The public pension plans I work with have open meetings, meaning that members of the public and various stakeholders have an opportunity to speak on various agenda items,” said Steve Hartt, a California-based principal at LP advisor Meketa Investment Group. He noted that fossil fuels and labour-related issues were the most common talking points.

“I’ve yet to hear anything significant from a geographic perspective, wherever it might be, China or otherwise, in terms of investments there.”

Geopolitical and economic uncertainty over China has not impacted appetites for the market in the past. Of the $643 billion raised for Asia-Pacific-focused private equity funds since 2008, just under 40 percent was for China-focused vehicles, according to PEI data.

One person who knows about Chinese private equity funds from a US perspective is Art Wang, who has invested in Asia private equity for nearly two decades, both as a GP and LP. Wang previously served as head of private investments at City and County of San Francisco Employees’ Retirement System, as well as head of private equity at NYSCRF, both of which increased their commitments to Asia private equity during his tenure and continue to be active in the region.

In 2018, Wang helped to launch FTPE, an investment management joint venture between global investment firm Franklin Templeton and Asia Alternatives, an Asia-focused fund of funds. Like Wang’s private investment portfolios at his previous institutions, FTPE’s private equity portfolio has substantial exposure to China.

“We seek partnerships with exceptional private investment managers who focus on fast-growing regions or sectors, wherever they may be in the world,” he told PEI.

“Like the US, China is a large and growing economy that is home to talented entrepreneurs who are building innovative companies and businesses. Importantly, our portfolio construction is determined not by top-down geographical asset allocation but rather as a result of disciplined, bottom-up underwriting of the world’s best private investment opportunities.”

Commitment issues

US public pension activity in China could nevertheless be impacted by other factors, such as the inability to travel and perform in-person due diligence.

“A lot of the public players I’ve been working with have tended to focus on those managers they know very well, and that has tended to be managers they’ve invested with for a long period of time,” Hartt said.

“The clients I work with are US-based, which has meant more of a focus on US and Western European managers who they’ve invested with two, three or four times over the years. There’s just not the same amount of history with the China managers or Asia managers in many cases.”

Those more familiar with Chinese private equity may have to consider the market’s historic distribution problem.

China was the best-performing venture capital market in terms of TVPI in 2018, delivering 1.72x versus 1.63x for US funds, according to eFront. As of May, China vintages between 2007-11 had generated a 0.8x DPI, versus 1.35x for their US peers, CEPRES data show. Likewise, 2011-14 vintages have distributed 0.21x in China and 0.69x in the US.

The country’s outperformance relative to western funds and comparative illiquidity can unbalance an investor’s portfolio – a dynamic that can be mitigated with fewer re-ups or new investments in regions with slower DPIs.

Even so, the growth driving China’s impressive TVPIs make the country hard to ignore. Since 1990, China’s official GDP growth statistics had not slipped below 6 percent per annum until Q1 2020 and, amid the pandemic, China’s economy is one of the few worldwide that is still projected to achieve positive growth for the year.

Adams Street’s O’Donnell said: “Appetites are reasonably robust among US public pensions plans looking to gain Asia, or simply China, exposure – these investors recognise the economic and demographic growth in the region as an opportunity to generate excess returns while adding appropriate geographic diversification to their overall portfolios.”

A subset of LPs remain sceptical, he added.

“Some US plans are hesitant to enter the Asia markets and need further convincing of the benefits of adding Asia [or] China exposure in order to create a well-diversified, risk-adjusted private equity portfolio.”