How are regulatory crackdowns affecting private market investors?
Over the past year, the Chinese government has made a steady stream of regulatory announcements covering overseas listing and a range of sectors, from private education and property to the technology sector. The list of concerns the government is seeking to address includes national security, data security, the effect of gaming on children’s development, economic inequalities through its drive for “common prosperity” and the power of large technology businesses. These interventions have battered public markets investor confidence. The China MSCI, for example, was down over 16% year to date at the end of September 2021 – and all at a time when most of the world’s stock indices have made significant gains.
But what about private markets investors? How spooked are they? To some extent, it depends on who you ask. “Interest among US-based LPs in China has a history of ebbing and flowing,” says Allen Huang, Director of Investments, Michigan State University. “A lot of the time that interest lags the returns, so when there are high-flyers catching peoples’ attention, they question whether they should have more in China and when there is some unpredictability, they sit on the sidelines. Some folks are driven by headlines and near-term focus. Yet among those who prefer to map out a long-term view on China, there is still a lot of interest – it’s just that the recent policy shifts have caused some investors to pause a little to see how it will all shake out.”
And it’s clear the suddenness of some of the announcements has caused some concern. “The erratic and idiosyncratic nature of the change creates anxiety and uncertainty among investors,” says a Partner at a fund of funds and secondaries firm. “Volatility has risen and there has been a pause in certain corners of the investment community.” And it’s hardly surprising, given the sweeping nature of some of the reforms, such as limiting the amount of time under 18s-can play video games, increased oversight of the algorithms used by platform companies, a ban on cryptocurrency mining and the potential to bar internet companies from listing overseas.
All this is certainly giving investors pause for thought, even if it is not having an impact on their current plans. “A lot of LPs are asking us what is happening,” says David Pierce, a member of HQ Capital’s global investment committee and its Chairman - Asia. “Over the past 30 years, we have generally regarded international political matters as beside the point and assumed there would be domestic issues from time to time as well. We currently have around 50% of our Asian portfolio in China and we won’t change our approach, but we do need to be more thoughtful than historically about what might happen. I’m paying a lot more attention to what happens politically than I used to, unfortunately, but that hasn’t changed our behaviour so far.”
In contrast to public markets time horizons, the long-term nature of private markets funds means that most LPs are taking a sanguine view of developments in China. “What we’re seeing is a big regulatory catch-up,” says the fund of funds and secondaries firm Partner. “It is transitioning China from the Wild West of technology regulation to something more akin to what we already see in the US and Europe. China is grappling with the issue of unbridled technology growth and the potential social consequences that result from any party being too powerful and having too much data advantage.”
Brian Lim, Partner and Head of Asia and Emerging Markets at Pantheon, agrees. “The regulations announced are not necessarily a bad thing,” he says. “There are parallels with what governments in other jurisdictions have tried to do in reining in big tech. The communication may not have been smooth, but the intent is clear.”
In fact, some investors, including Lim, believe the changes could usher in new investment potential. “You have to take a step back and understand the context in which the government operates and how that relates to investment opportunities,” he says. “If it is successful in checking the dominance of big tech, that levels the playing field and could well have a positive impact on early-stage ventures.”
The changes are also having limited impact on day-to-day private markets activity in China. “The overseas sentiment around China doesn’t match with what we’re seeing on the ground,” says Nicholas Lee, Managing Director, Morgan Creek Capital Management. “Deal activity continues at a high level and exits are happening as normal. VCs have continued to deploy capital. It’s very clear as to which sectors are affected by the regulation and the government is warmly welcoming foreign capital – China is still open for business.”
This is reinforced by the fact that GPs in China and Asia are more generally accustomed to uncertainty, shocks and volatility than their US and European counterparts. This should mean that they are well placed to take advantage of any shifts. “When we evaluate current and prospective GPs, we are trying to assess how they might pivot, if at all, to the regulatory changes afoot in China,” says Ed Grefenstette, President and Chief Investment Officer at The Dietrich Foundation. “Overall, we give Chinese GPs much higher marks for agility than their US counterparts. We expect the strategies of Chinese GPs will swiftly and appropriately evolve in response to market conditions and, once the regulatory dust settles, China VC investing environment will actually be cleaner and healthier for early-stage companies by allowing them more latitude to challenge incumbents.”
Sentiment among LPs, therefore, remains largely positive on China despite the lack of warning around the announcements. Many suggest the opportunities in China are just too great to miss and that the long-term picture looks brighter as a result of the regulatory change. As Philipp von dem Knesebeck, Managing Partner at BlueFuture Partners, says: “Western investors tend to understand China poorly because there is a lot of negative press. The regulatory changes in China are positive because they will root out fraud and abuse and create a much better environment for investors.”
