In less than a decade, the Silk Road has evolved from a historic trade route connecting East and West into a thriving online black market. In much the same way, China’s ageing smokestack industries are being forgotten in favour of a new generation of digital titans.
This ‘New Economy’ is a loosely defined collection of sectors, many of which are linked to China’s digital revolution and increasing domestic consumption, that have attracted massive amounts of capital in the past decade. Examples include, but are by no means limited to, advanced manufacturing, e-commerce and healthcare.
“Relative to other parts of Asia, the China portfolio has delivered some pretty incredible returns over the past decade,” Yup Kim, senior portfolio manager at Alaska Permanent Fund Corporation, tells Private Equity International. “While parts like consumer internet are slowing and maturing, there’s still so much about the New Economy opportunity set, like applied AI, enterprise technology, healthcare and biotech, 5G, internet of things, etc, that remain compelling in the decades ahead.”
As the New Economy matures, momentum appears to be slowing. At the time of writing, China, once the epicentre of the covid-19 pandemic, is returning to relative normalcy and some estimates put at least three-quarters of the workforce back on the job. But China has not truly enjoyed ‘business as usual’ since even before the virus emerged.
Headline risks have come to dominate much of the discourse around China in recent years. Trade tensions with the US under the Trump administration and the West’s growing unease around its reliance on Chinese technology have exacerbated a mounting domestic slowdown.
China’s GDP grew 6.1 percent last year, a 29-year low, and contracted for the first time since records began in Q1 2020. Privately owned corporate bond defaults also hit a record high of 4.9 percent as of November, according to data from Fitch, and in January, the People’s Bank of China curbed the interest rate local banks can offer on certain deposit products to encourage lending to corporates and stimulate the economy, Reuters reported.
Specific instances have also caused concern. US-listed Luckin Coffee, one of Chinese private equity’s banner success stories, has become embroiled in an accounting scandal relating to alleged fraudulent revenue figures. TAL Education, another US-listed Chinese company, is also probing sales fraud.
Chinese dealmaking has slumped. Transaction value fell 38 percent to $63 billion in 2019 and was 16 percent below the 2014-18 average, according to Bain & Co’s Asia-Paciﬁc Private Equity Report 2020.
Nowhere has this shortfall been more evident than in the New Economy, with investments into Chinese tech and internet assets dropping 42 percent last year to $30 billion, versus a 23 percent drop across Asia-Pacific. The number of deals over $500 million also fell to two from 10 in 2018.
“Chinese strategics have become very active in acquisitions because the political situation means they’re spending less in the West and reallocating outbound investments to the domestic market”
Anthony Siu, BDA Partners
Private equity capital flooded into China post-crisis. Of the $568 billion raised for Asia-Pacific-focused private equity funds since 2008, roughly 39 percent was for dedicated China vehicles, according to PEI data. This is not to mention the significant buckets of capital earmarked for China in pan-regional mega-funds.
Much of the country’s appeal lay in its New Economy, which accounted for almost 85 percent of the growth in Greater China private equity investment value between 2010 and 2018, according to Bain & Co research. Some 80 percent of Greater China-focused funds were considering or actively pursuing New Economy deals as of 2018.
China claimed more than 70 percent of the total value of Asia-Pacific internet and technology private equity deals in 2018, with $59 billion deployed – more than 20 times what was deployed in Greater China in 2010.This remarkable growth has caused headaches for investors, with some complaining that a desire among China managers and company founders to add a telecommunications, media and technology angle to their businesses could leave portfolios over-exposed to the sector.
“Aspirational GPs, as well as entrepreneurs, very much want to make their companies in the mode of technology companies and have every incentive to enlarge that technological layer into being the core of the company,” Jie Gong, partner at fund of funds Pantheon, told delegates at an industry conference last year. “Being an LP, that presents somewhat of a challenge because from a diversification point of view you don’t want your whole portfolio to look like an overall tech fund.”
Last year’s dealmaking slowdown has been attributed in part to the introduction of strict asset management rules in 2018, which made it harder to raise yuan-denominated funds from Chinese investors. Firms raised just $4.8 billion across 14 renminbi vehicles in 2019, compared with $9.3 billion over 25 funds the previous year, according to PEI data.
China insiders note that it is near impossible to get an accurate picture of domestic investments. According to S&P Global Market Intelligence, Chinese private equity managers deployed just $47 billion at home during the first 11 months of 2019, roughly half the $88 billion invested in 2018.
Reduced domestic firepower tells only part of the story, as international investors had also deployed just $5 billion in China at the end of November, a 64 percent decline from 2018. The country did, however, pass a Foreign Investment Law in 2019 to encourage private equity investment by relaxing rules on distribution waterfalls and oversight of stake sales, among others.
Some buyers may have been deterred by pricing, with 90 percent of firms surveyed by Bain & Co saying it is difﬁcult to evaluate companies in the New Economy. Some 63 percent said this was due to high prices and 62 percent cited the inability to rely on traditional private equity valuation techniques.
“Chinese consumer internet companies have been innovating their business and revenue models at a more rapid pace and benefit from supply chain and distribution channel advantages,” Kim notes. “If you’re a US firm trying to acquire a Chinese consumer business, it’s not easy to use traditional mature market frameworks to assess intrinsic value as many pattern recognition insights based on the past 20 years won’t necessarily apply.”
Next-generation assets in Asia, including cross-sector businesses such as healthtech, commanded a 26x enterprise value-to-EBITDA entry multiple between 2017-19, compared with just 13x for unrelated sectors. Prices are also driven in part by rampant appetites from cash-rich corporate giants such as Baidu, Alibaba and Tencent, or BAT, which collectively have invested more than $4 billion in China since January 2018, per S&P Global Market Intelligence.
“Chinese strategics have become very active in acquisitions because the political situation means they’re spending less in the West and reallocating outbound investments to the domestic market,” says Anthony Siu, a Shanghai-based managing director at investment banking advisory BDA Partners.
Chinese FDI in Europe fell 40 percent to $13.5 billion and in North America fell 27 percent to $5.5 billion during 2019, representing the lowest combined total since 2010, according to law firm Baker McKenzie.
“Some PE firms will have lost out to cash-rich corporate buyers as they’re seeking a minimum financial return and need to show price discipline,” Siu adds. “However, we are seeing more PE firms as price leaders in auctions recently because there’s a limited number of top assets.”
Running out of steam
Whether New Economy assets justify their price tags has yet to be seen, but their peers in the public markets provide something of a window into the sector’s condition.
A China corporate health monitor by French bank Natixis in November found “rapid deterioration of financial health within the New Economy”. The research, which analysed the top 3,000 listed corporates in China, said ICT and semiconductor companies in particular were among the country’s worst-performing sectors relative to their global peers.
“Private equity valuations have been crazy, but that kind of pricing didn’t reflect either the past or the current revenues for these companies,” Alicia García Herrero, chief economist for Asia-Pacific at Natixis, tells PEI. “It’s a case of exaggerated expectations and the revenues never materialised.”
Operating income for New Economy companies fell 12 percent year-on-year in H1 2019 and 9 percent in 2018, despite enjoying 24 percent growth in 2017. Performance has been impacted by slower growth in household disposable income and the US-China trade war, García Herrero notes.
Meanwhile, China’s old economy, such as industrials, automobiles and real estate, grew operating income by 28 percent in 2018 and 3 percent in H1 last year. The New Economy has, in some ways, been a victim of its own success: rampant consumer appetite has created industry leaders that are near-impossible to topple and saturated the pool of potential customers.
“Private capital has been increasingly focused on the larger players who, as a result, are well-capitalised and have focused on improving their business, making it harder for new players to stand out.”
Oversaturation in the consumer sector may result in investors pivoting from a focus on B2C to B2B. “China has created its consumer tech champions and entrepreneurs will have aspirations to do the same for healthcare, enterprise software plus logistics and different types of applied emerging technology,” Kim says. “And there’s full government support in some of these areas to build durable competitive advantages at the global stage. There’s a real opportunity for continued long-term equity value creation.”
China’s soaring valuations in recent years have impacted performance. Return multiples in the New Economy fell to a median of 2x from 2017 to 2019, compared with 4x for investments exited the previous three years, according to Bain & Co’s report.
Just one in five exits between 2017 and 2019 generated multiples of more than 4x, compared with around half of the deals exited in 2014-16. It is unclear whether these returns are net or gross.
Zhang remains sanguine, noting that a higher return is associated with greater risk. “The asset class delivers 2x, paralleling the maturing state of the New Economy; it may indicate lower risk compared with the venture or growth stage, and that could be the right time for a PE investor to get into the sector if there’s greater conviction in the returns.”
“The population of investors you could go to has shrunk […] The hurdle of getting a re-up is higher than usual and a lot of groups are delaying new fund relationships”
Vince Ng, Atlantic-Pacific Capital
Like much of Emerging Asia, China also has a distribution problem. Chinese private equity funds with vintages between 2007-11 have generated a 0.8x distributed-to-paid-in multiple, versus 1.35x for their US contemporaries, according to CEPRES. This trend continues for 2011-14 vintages, which have 0.21x DPIs for China funds and 0.69x in the US. Asia’s predilection for minority growth investments, which are harder to exit than in situations where a manager is the sole or control owner, is partly to blame. This does not look set to change: growth transactions have accounted for an increasing proportion of Chinese deals for the past five years, according to Bain & Co.
China became the top-performing market for venture capital in terms of total-value-to-paid-in in 2018, generating 1.72x versus 1.63x for US funds, but also had one of the longest times to liquidity; most of the value was unrealised, according to data from software provider eFront.
“New Economy assets would traditionally raise capital, burn cash and then go public, but this is no longer the case because events like WeWork have affected New Economy sentiment towards IPOs,” Siu notes. “A lot of minority investments have been tied up [and] they are seeking late-stage funding to delay going public.”
China’s lofty TVPIs and comparative illiquidity can unbalance portfolios – a dynamic that is already playing out within its venture capital market.
“High TVPIs in Chinese VC can alter an investor’s overall exposure to the market,” a global placement agent with offices in Hong Kong told PEI in February, noting the phenomenon had impacted international commitments to fundraising. “Going forward they can’t keep investing at the same rate and have to write smaller cheques to these funds.”
Fundraising has – to some extent – bucked the trend: China-focused vehicles raised $26 billion in 2019, the highest total since 2011, according to PEI data. The largest of these was the $4.25 billion Warburg Pincus China-Southeast Asia II, followed by the $3.4 billion Primavera Capital III and $2.8 billion CITIC Capital China Partners IV.
The country also yielded several impressive first-time raises last year. DCP Capital, founded by two former KKR partners in 2017, collected $2.5 billion for its debut fund and Centurium Capital, brainchild of a former Warburg Pincus executive, raised $2 billion for its first dollar-denominated fund.
Karen Zhang, KKR
The data can flatter to deceive. “China’s still had a very strong fundraising market over the past 18 months but a lot of this was driven by brand-name funds and spin-outs,” Niklas Amundsson, a Hong Kong-based partner at placement agent Monument Group, tells PEI. “Some funds also started raising capital in 2018 but found the process took much longer than expected and only reached final close last year, which has inflated the numbers.”
Delays are linked – at least in part – to fractious relations between East and West. Beyond concerns around the impact of tariffs between China and the US, the West has become warier of Chinese technology and infrastructure due to concerns over spying. The country has also taken a public relations beating due to civil unrest in Hong Kong and its treatment of Uighurs in Xinjiang.
“The population of investors you could go to has shrunk,” Vince Ng, a Hong Kong-based partner at placement agent Atlantic-Pacific Capital, said in December. “And because a lot of groups don’t think it’s the best time to take a China fund to their investment committee, the hurdle of getting a re-up is higher than usual and a lot of groups are delaying new fund relationships.”
Regardless, the timing of last year’s fundraises could be fortuitous as coronavirus has the potential to reset overheated valuations for assets that are marked to market.
“New Economy valuations may come down because they’re typically driven by the public markets, given that many exit via IPO, and the stock market decline had a knock-on effect on pricing,” Siu says.
Longer holding periods
Although a sharp decline in TVPIs might – counterintuitively – prove a welcome respite for investors sweating over their exposure to the region, there’s also the risk that it prolongs holding periods even further as deal activity slows or GPs wait for a better price. Some firms with exposure to renminbi LPs have already begun secondaries processes to assuage or pre-empt investor frustration.
“Many of the Chinese RMB LPs want to see [distribution-to-paid-in],” one managing partner of a Beijing-headquartered growth equity firm that has recently undertaken a GP-led transaction tells PEI on condition of anonymity. “After we’ve done this deal […] we can return a significant chunk of money to our existing LPs, which can be very attractive to our RMB LPs.”
Meanwhile, advances in technology mean the opportunity set and pool of potential customers is ever-changing; what’s considered to be New Economy now could be as antiquated as the steam engine in the not-too-distant future.
“The first wave of spending in the New Economy is almost at an end and the market is waiting for the next wave, which might consist of investments into the cloud, AI and big data technologies,” Zhang says, noting that this could take another three to four years to reach initial critical mass.
Kim adds: “It’s impossible to expect double digit growth into perpetuity for China’s New Economy [and] once scale and breadth have been reached in end markets, growth will inevitably decelerate. Major demographic shifts from rural to urban areas and increased demand for high quality healthcare by an ageing patient populations will continue over the next 20 years and, while there might be plenty of bumps along the way, you’ll miss out on a lot of equity upside if you’re not invested for the long-term.”