The bubble debate

Countless surveys and statistics have shown that LPs globally are allocating more money to China, and that China has been leading the fundraising activity. As one European fund of funds manager puts it “no one will say no to exposure to China.”

However, at the same time, some Western LPs are worried that too much money is flowing into China and in particular that there is a bubble forming in China’s private equity market.

Shenzhen Stock Exchange: used to volatility

In addition to foreign investors, the emergence of domestic institutional LPs, such as National Social Security Fund (NSSF) and – as of this September – insurance companies, and the increasing number of high net worth individuals and wealthy entrepreneurs all contribute to an increasing amount of money in the market.

“If you look at the Hong Kong and Shanghai home prices, it is obvious how much liquidity there is in the system,” says Vincent Huang, a Hong Kong-based partner with fund of funds group Pantheon. “There is certainly an asset bubble. There are only two marketplaces in China which are large enough to absorb this liquidity – the stock market and real estate.”

Because the stock market is absorbing the liquidity, LPs’ are concerned that pre-IPO investment is to common a strategy in Chinese private equity. Going public for Chinese companies means not only raising money, but also gaining prestige.

However, there has always been a “bottleneck” in China for companies to be listed, according to Huang.  “As a result, there’s always a discount to public valuation in private transactions,” he says. “This has encouraged a more hedge fund-like mentality rather than traditional private equity, where the means to generate return is through value creation. Unfortunately PE in China has been more about the arbitrage play between public and private markets.”

CHINEXT FEVER

The situation has somewhat been exacerbated by the establishment of ChiNext, a NASDAQ-like stock exchange in Shenzhen which acts as an alternative platform for startups and smaller companies to be traded with fewer listing requirements than the nation’s two main boards in Shanghai and Shenzhen.

Formed a little more than a year ago, ChiNext was home to 137 companies as of 10 November this year. About 59 percent of the companies listed on ChiNext are backed by venture capital or private equity firms, compared with 35 percent traded on Shenzhen’s SME board, according to CVSource, a China-based research group that focuses on private equity and M&A.

“There’s a bubble in certain segments of the public market,” says Jie Gong, vice president of Morgan Stanley Alternative Investment Partners. “If you look at ChiNext, a lot of the valuations are clearly not sustainable – they will have to come back to earth at some point. Any USD or RMB investors whose sole value creation angle is to exploit a public/private arbitrage in that market are sailing close to the wind.”

In fact, the average price-earnings ratio was 76.67x on ChiNext at the time of writing, compared with an average of 58.75x on the SME board and 38.94x on Shenzhen’s main board.

Returning to the two markets that are absorbing the liquidity in China – the real estate and stock markets – it is anticipated that there will be some correction to the currently heated market situation. Unfortunately for public market investors, the correction is less likely to be in the real estate market.

A CORRECTION IS COMING

“The demand for property is pretty inelastic given the rate of urbanisation and rising income and it will create serious social issues if the property market collapses. However, the stock market can withstand much higher volatility,” says Huang. “Corrections happened many times before and people in China have built pretty strong tolerance for risk in the stock market. So a somewhat stable property market at this level and volatile stock market is probably how it will play out,” he predicts.

So if the stock market is bound to be bearish sometime in the future, pre-IPO plays are to bear the brunt. The good news is, most GPs are aware of it.

A Beijing-based management consultant notes that local GPs who have been investing purely in pre-IPO plays have approached his firm to learn how to add value, because they realise there are only a couple of years left in this strategy and that it is highly competed.

“I think most people do realise pre-IPO is not a sustainable model for private equity,” agrees Jason Zhang, managing director of investment at fund of funds Morgan Creek Capital Management. “You’re relying on the capital market to stay strong, and that’s not always going to be the case.”

But it might take some time to put theory into practice.

“More and more funds are realising the need to add value in the long-run and are building in-house operational expertise accordingly – although not enough are doing this yet,” Huang acknowledges.

In addition to pre-IPO investment where people see a potential bubble, another factor worrying LPs is that most capital goes to the same sectors and regions in China.

“Some 94 percent of private equity year-to-date has gone towards the Eastern and coastal regions, which now accounts for only 58 percent of the economy. Then around 44 percent of all deals happen in the technology sector, including alternative energy and internet. This is clearly a more speculative sector and it’s certainly not 44 percent of the Chinese GDP,” says Derek Sulger, founder and managing partner of China-focused Lunar Capital.

CAPITAL CONCENTRATION

“If we look at technology, healthcare, even consumer retail, we see an awful lot of private equity firms transacting at prices that are too aggressive,” he adds.

The capital concentration is leading to competition, and so “there will be situations where people pay higher prices or people will have less stringent terms”, Zhang says, adding: “If this trend continues, when you have more and more capital rushing into the market, you could potentially get into a more bubble-like situation.”

Nevertheless, China is a large market and private equity investment activity in the nation is still relatively small. “How many $5 billion or $10 billion funds are there in the US and Europe? You could probably name about 10. In China there are none and yet China is now the second largest economy in the world,” says Sulger.

For now, “there is not a bubble per se in China. If you look at the size of the private equity industry as a percentage of GDP it’s a fraction of what it is in other markets. Private equity here is at the end of the beginning – by any method that you look at the industry it’s under-penetrated,” says the management consultant.

In fact, while the market is competitive, it is generally perceived that opportunities are there.

“When you look at the constraints private companies face to secure long-term bank lending in China, and the scope of professionalisation and improvements that are needed to bring companies to scale, there is still a lot of opportunity for private equity capital in the earlier stages of a company’s life,” Morgan Stanley’s Gong says.

LPs meanwhile are eying the market with mixed emotions. Says one fund of funds manager: “LPs think there’s a bubble being formed in China. However, they can’t resist the market.”