China special: The market comes of age

Talk to any private equity executive in China and it soon becomes clear that this is a market growing in maturity. From sector-specific funds to more sophisticated deal terms, the private equity industry has made giant strides from its hesitant first steps 20 years ago.

From January 2011 to March 2016, China attracted the most capital among markets in the Asia-Pacific region, garnering $76 billion of capital commitments from investors, according to PEI’s APAC Fund Manager’s Guide. The average fund size of China-focused vehicles also doubled – from about $300 million in 2008 to $660 million in 2016, PEI data indicates.

Chinese private equity firms Hony Capital, CITIC Private Equity and Primavera Capital are leading the charge, each raising between $4 billion and $9 billion since 2008. Last year, Beijing-based Hony raised $2.7 billion for its latest buyout fund, Hong Kong-based FountainVest Partners scooped $2.1 billion for its growth capital fund, while Primavera raised $1.9 billion for its second buyout vehicle, significantly larger than its $432 million predecessor fund.

A report by PwC China, which also includes venture capital fundraising, revealed that yuan-denominated funds became a dominant force in the market in 2016. More than $72 billion was raised by China private equity and venture capital funds in 2016, with over two-thirds held by yuan funds.

Capital raising has kept its momentum and so has dealflow even amid slower growth in the macro environment, heightened competition for deals and a limited supply of high quality targets. Greater China deals in 2016 totalled $49 billion across 439 transactions, representing a 30 percent increase in deal value compared with the 2011-15 average, data from Bain & Company show.

David Pierce, a Hong Kong-based managing director and head of Asia for fund of funds manager HQ Capital, says China is now established as the largest private equity market in Asia, a position it is set to consolidate.

“Within that market itself you have a lot of diversity in terms of the kinds of funds that are being raised, the strategies that are being pursued, the sorts of people raising those funds, the investors committing capital to those funds – we have seen a lot of development in a fairly short time.”

Pierce adds the firm has seen a new maturity among Asian private equity investors.
“First, we’ve seen people developing expertise just by doing. Private equity is very much an apprenticeship industry; until you have done a number of transactions you really can’t say you are a private equity investor. It’s one thing to originate a transaction, and another thing to actually make a deal, execute the deal, manage through the asset, as well as exit and get money back to investors.”

The ability to add value over the course of the investment also shows how the industry has matured. Pierce notes that a lot of private equity investing in the early years was simply providing capital to fast-growing Chinese companies that couldn’t get it from banks or from public markets. And the way to get growth capital back then was from private equity funds, with the simple plan that the company would grow rapidly and go public.

“There’s now much more emphasis on actually adding value by helping the company in various ways and that requires bringing on board professionals with other skillsets with actual operating experience, not just deal guys.”

That level of progress is also observed in cross-border transactions – a growing trend that saw Chinese private equity firms and strategic investors close nearly 260 deals worth over $185 billion in 2016, according to Mergermarket.

Alez Zhang, a Beijing-based partner at international law firm White & Case, says Chinese buyers are getting more sophisticated in dealing with US regulatory issues, are better informed and are increasingly engaging advisors to stop deals from being reviewed by the Committee on Foreign Investment in the United States.

Zhang adds that private equity firms are also increasingly partnering with Chinese strategic buyers in deals. “In any event, if the private equity firm is a US dollar-denominated fund, it is better positioned to work with a strategic in dealing with the currency issues.”

Growth funds remain the strategy getting the most capital, but buyouts are on the up, says Mei-ni Yang, a principal at Mercer Private Markets.

While there’s still a large amount of capital raising across venture capital funds pursuing disruptive technologies such as ride sharing, online media and e-commerce, she notes that buyout transactions will increase for two reasons. “First, it’s driven by slower economic growth in China. And second, Chinese companies are generally warming up to the private equity value proposition and are more willing to give investors control and real influence over value creation.”

The industry has also witnessed an increase in sector-specialist funds, especially in healthcare, consumer, media and technology.

One reason for this is the high valuations caused by the abundance of capital, Yang says. Firms also find that when they survey the landscape they can’t just afford to be a sector generalist; they need to be more sector specific in order to generate more value-add and to find good deals.

Market watchers also note that a new group of limited partners has emerged in recent years, buoyed by the explosion in the wealth management sector and deregulation in the insurance sector.

Yang says Chinese insurance companies, which were only allowed to invest in private equity in 2012, have been active in pursuing private market investments. China Life Insurance and Ping An Life Insurance – the country’s top two insurers by size of assets – are aggressively deploying capital into private equity.

The $300 billion Ping An has been diversifying its asset base away from fixed income investments and into alternatives, with private equity investments increasing from 25.9 billion yuan ($3.8 billion; €3.5 billion) in 2013 to 38 billion yuan in 2016.

Meanwhile China Life, which expects to allocate up to 5 percent of its overall $350 billion portfolio to alternatives, is looking to hand more mandates to overseas fund managers.

Yang says China’s LP base is now much broader and becoming more sophisticated, including some of the local wealth management firms that have started their own asset management arms and are raising funds of funds, such as Noah Holdings and CreditEase Wealth Management. “The LP landscape is increasingly more diversified and less government-driven.”

Pierce agrees: “In terms of private capital there’s a lot of interest from Chinese high-net-worth individuals to invest in alternative assets, both in yuan and other currencies. We’ve also seen a big growth in the wealth management sector – some of their clients are becoming LPs now, while some of them are finding private equity a little bit dull because the asset class is a slower burn than they are used to.

“Many Chinese entrepreneurs made their money rapidly. They’re used to getting quite good returns on fairly short timeframes, so the idea that a private equity fund might achieve mid-teen returns over the course of seven to 10 years is not very sexy to some of these guys.”

“There’s probably an expectation management issue, there’s also the understanding of asset allocation and building long-term portfolios that’s needed.”

One driving force behind the growth of the industry in recent years is the shift in government policy towards developing the private equity industry and encouraging the diversification of capital sources for companies to include private equity investments.

“We are seeing the Chinese government trying to develop regulation of the asset class and that’s to be expected. But it’s not the heavy-handed regulation you’ve seen in some other markets, it’s just designed to bring some order,” Pierce notes.

“We see continued growth and development in the Chinese private equity market and don’t see any reason why it should stop. One of the big differences between the West and Asia generally is that private equity is welcomed here, it’s not seen as a threat or danger. In China it is an important part of the country’s capital formation environment and we expect that to continue.”