Private equity: how to get ahead in changing China

Opportunity and risk abound in China's hyper-competitive private equity sector amid a liquidity glut.The spectre of regulatory disaster is never far away.

China is an ever-evolving investment landscape for private equity funds.

With diverse and fast-changing consumer preferences, constant technological innovation and the prospect of regulatory obstacles kicking in at any moment, the world's second biggest economy offers immense opportunity – for those who avoid some alarming pitfalls.

“Almost every half a year, there’s a new theme,” said Gilbert Zeng, co-head of China at Standard Chartered Private Equity, an investment arm of the British bank that focuses on emerging markets. He cited online-to-offline platforms, fintech start-ups and more recently, the rise of artificial intelligence players in China, as examples of capital darlings in recent years.

But picking the truly valuable assets from a vast array of emerging themes is where private equity managers really earn their money. And for US dollar funds, it's made all the harder by increasing competition from rising local rivals – not to mention .

Some 1,675 renminbi-denominated private equity funds raised capital in China last year, hitting a record total of Rmb996 billion ($150.79 billion), according to data provider Zero2IPO Research.

Beijing's foreign exchange controls leave a vast pool of renminbi liquidity trapped onshore. That, coupled with a clampdown on the real estate market and volatility in onshore equities, has left renminbi liquidity flooding into alternative investments.

“I can see a lot of money wanting to get into the private equity world,” Zeng told the second global advisory meeting of AMTD Group last week.

One key factor is the growing investment clout of Chinese industry giants like the so-called BAT – an acronym for Baidu, Alibaba and Tencent. The trio bring not just capital but also industry expertise and strategic value to the start-ups they work with. For dollar funds, that means “we have to refine our investment strategies”, Zeng said.

Denis Tse, managing partner of private equity firm Asia-IO Advisors, echoed that view. “Regulation definitely played a very big role” in the last 12 months, with M&A curbs causing a significant drop in deal volume for cross-border transactions, he said, adding it also creates more block-trade opportunities for private-equity firms.

“I feel the very aggressive players are now getting hands tied down, and some of them [are] even forced to sell stuff, so that creates some interesting direct secondary opportunities for other players,” Tse said.

But overall, asset valuations are surging – although whether they are now at unreasonable levels is open to debate.

“Competitions become more and more brutal …and founders of companies are happy as they are selling [at] a good price,” said Neil Wang, chief investment officer of AMTD Strategic Capital Group, who sat on the same panel.

Valuations out of touch with reality?

That is consistent with what Michelle Li, head of research at AMTD, found in a survey earlier this year asking investors: “At what stage is the most expensive valuation they get in fintech start-ups?” Tellingly, Li said, the answer came back that it was the series C round – a stage when PE players typically get involved. 

“You need to find a balance between a company with good management and strategy and a visible valuation – that’s very difficult,” Li said.

In almost every investment theme that has emerged in China, there has been a fierce contest between dozens, if not hundreds of, start-ups of all sizes. Bet on the wrong one and you'll burn your money to dust, but tailing top players means investors have to sacrifice bargaining power.

Take bike-sharing for example. Despite being arguably the most exciting new play in China this year, it is yet to make a profit. And the two frontline players – Ofo and Mobike – have collected more than $2.5 billion between them from a group of industry giants, top local funds and big-name foreign investors. Bluegogo, which claimed to be the industry’s number three in terms of market share, went bankrupt this month and could not return deposit money to users.

“If you are the number four player in China, we’ll never invest in you,” said Zeng of China’s investment frenzy and fierce competition among start-up businesses.

However there is another option for private equity funds who miss out on the hottest of Chinese start-ups. Look at whether the business model could be exported.

“China's capital is now being deployed globally and Chinese business models are also being duplicated, especially in the Asia region,” Zeng said. Chinese-speaking entrepreneurs in, for example, Southeast Asia, are localising Chinese business models. He shared the example of the online short-term  lending business – a field already so crowded in China that regulators have started a clampdown on it. In Indonesia, a Chinese entrepreneur came to Standard Chartered Private Equity for early investment in a similar scheme, according to Zeng.

By happy coincidence, investing in a successful Southeast Asian “copycat” of an established Chinese venture offers an obvious exit for private equity. After all, Chinese industry giants have ambitious expansion plans globally, and Southeast Asia is an obvious first stop for them.

“Always, there’s an exit – to sell to the BAT,” Zeng said.

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