The China conundrum
Once the go-to Asian market, recent years changes have given allocators pause for thought. So how are investors viewing the market today?
Investors need to look beyond the headlines“Our total exposure to China peaked in late 2020,” says Ed Grefenstette, President & CEO of the Dietrich Foundation. “Since 2006, we’ve felt strongly that the geopolitical and regulatory risks assigned to China by most foreign investors were, in general, outside reality. Yet today, investors face new and significant questions that compel even the most experienced China investors to re-assess regulatory and geopolitical issues. We believe it’s essential to come and collect information first-hand, as opposed to relying on media coverage, which is noisy at best. While that kind of travel has been difficult for the past couple of years, it’s possible today. We are still assessing the risk and opportunities we see and haven’t yet decided whether the expected returns will adequately compensate for the new structure of risk in today’s China.”
It’s a question of risk-reward
“We are long-term investors in China,” says Liang Yin, Head of Private Equity, Asia-Pacific, at WTW. “Like everyone else, we are grappling with how and how much to invest in China today. Parking geopolitical risk aside as that is very much in the eyes of the beholder, we have to look at the economic and investment arguments. I strongly believe that globalisation is reshaping into a more regionalised structure and that presents opportunity for investors sitting outside the economic bloc led by China.
Via that lens, the investment case for China actually becomes stronger because the cash flows you can generate in China will be even less correlated with your home markets. It’s also an $18 trillion economy that is growing at 5% - so by the end of 2023, its economic scale will be $900 billion bigger than at the beginning of the year. And finally, the argument about China has become often too binary – is it investable or not?
Yet risk is rarely an on/off switch. You have to look at opportunities from the bottom up and ask: am I going to be rewarded on a risk-adjusted basis?”
What comes next?
“China continues to be an important part of our portfolio,” says Liam Coppinger, Head of Private Equity Asia at Manulife Investment Management. “But the question is how we access China – should that be via China-focused or regional funds? Currently we do both and we do look at some co-investment opportunities. There are clearly some sectors we don’t focus on, although we don’t see factors such as the US’s new executive order on Chinese AI, quantum computing and semiconductors having a significant impact on private equity. That said, it does signal a change in the overall risk environment. We’ll see how the rules and restrictions play out, but we do have to consider what could come next.”
Beware regional creep
“Investors have done well in China, but there was clearly hype around the market,” says Sean Warrington, Head of Private Investment at Gresham Partners. “There is now an exodus of capital and the question to ask is: as capital exits China, is it going there for the right reasons or is it going for diversification? If it’s the former, great, but if it’s just for diversification, it is unlikely to achieve the right outcomes. There is a legitimate reason for Chinese GPs to back Chinese entrepreneurs in different regions, but if it’s just to deploy capital, investors should run for the hills – every country that isn’t China is probably benefiting from capital flight from China, but investors need to see fundamental business growth to be excited.”
This is a watershed moment
“In a few years’ time, we’ll look back at today as a watershed moment,” says Chengeng He, Co-Founder and Manging Partner at Dayone Capital. “Post-2008, we saw an injection of capital from investors into VC and PE funds looking for yield enhancement in a low interest rate environment. Over the decade that followed, many China VCs, especially dollar-denominated ones, were able to deliver returns that were higher than developed markets but with lower volatility than emerging markets. Yet Chinese VCs can no longer generate returns based on the sheer volume of capital flowing into the market; the new normal is value creation. Less will be more – VCs will need to do fewer, more focused and specialised deals, go deeper and create value.”
It’s a good time to be contrarian
“After 30 years of rapid growth, China is seeing its first recession,” says Boyu Hu, Founder & Partner of XVC. “Investor and consumer confidence are at an historic low. Over the past two years, we’ve seen many large investors move away from consumer-centric investments and into high tech and frontier tech – many have shut down their consumer teams. We are now in the minority and it’s a great time to be here because there is a lot of opportunity and valuations are now down by around 70% from their peak in consumer.”
It’s a bottom-up game
“When LPs look at whether they want exposure to China, they need to avoid double-counting risks,” says He. “If the risk analysis at a high level, including geopolitical risks leads to the answer that they do want exposure, they shouldn’t re-integrate geopolitical risk when look at individual opportunities. Investors need to take a deeper look as opposed to simply looking at average and aggregate numbers because that’s not where returns lie. Alpha comes from the bottom up.”
Wait for the exit
“It’s currently not easy to promote a China story to international markets,” says H. Chin Chou, CEO, Morgan Stanley Private Equity Asia. “The operating environment in China hasn’t been too bad and certainly not as bad as news reports suggest, but for many owners of assets in China, it’s probably best to batten down the hatches and wait for the time when you can create buyer tension among M&A buyers or the public markets.”
Going beyond the obvious
“There continues to be quite a lot of investment on the RMB side and frankly it remains expensive,” says Chou. “We are seeing plenty of club deals chasing areas such as EVs and lithium batteries and other areas that are currently in fashion, but they are being done at 25-30x earnings.
Given macro uncertainties around the world, our strong preference is to avoid these highly priced growth deals in Asia, particularly when entrepreneurs continue to value their businesses at unrealistically high levels. We see best value in corporate carve-outs or situations where individuals are challenged and want to sell non-core assets for liquidity.”
