A year ago, China's private equity sector was enjoying a boom, with new funds arriving at a rate of almost 10 a day and investors splurging trillions of renminbi in the hope of enjoying high returns.
What a difference 12 months makes.
Beijing-based data provider Zero2IPO Research said 3,574 funds launched in a feverish 2017, raising approximately Rmb1.8 trillion ($229 billion) from investors. Only a handful, roughly 70 in total, were not renminbi denominated, according to one leading private equity investor.
By contrast, in the first quarter of 2018, just 805 new renminbi private equity funds were registered, with only Rmb237.6bn of capital, according to Zero2IPO’s analysis.
Chinese private equity investors say the key issue is a drying up of liquidity as Beijing's regulators turn the screws on easy money from the asset management sector and global policymakers turn off the taps after almost a decade of loose monetary policy. What's more the sector is wrestling with bloated valuations and difficulty in exiting investments – trends which could weigh against new fund launches.
“In five years, active [newly-launched] private equity funds may drastically drop to a few hundred [per year] from the current several thousand,” said Yonghua Wang, chairman of Shenzhen-based private equity fund Tiantu Capital.
Wang, whose consumer-focused fund has some Rmb10 billion of assets under management, was speaking at the Hong Kong Venture Capital Association's 17th China Private Equity Summit in Hong Kong this week.
EASY MONEY DRYING UP
There was little dissent among speakers at the summit that excess liquidity was the main driving force behind private equity mania in China last year. Equally, it's clear the loss of that liquidity is a key challenge for the sector today.
Between 2014 and 2017, China's M2 money supply ballooned by over Rmb40 trillion to Rmb160 trillion – of which "some was injected into financial markets via various asset management instruments, rather than going to real economic sectors," Zhao Yuanqi, a partner at Beijing-based fund of funds Prosperity Investment, told the summit.
On the back of a surge in domestic base money supply, huge institutional investors including government-led funds-of-funds poured much of the easy money that flowed in into the private equity sector.
But the boom in liquidity left markets bubbling, and regulators became increasingly concerned about systemic risk.
Starting late last year, Chinese policymakers initiated a macro-level deleveraging campaign. That drive "goes to every sector of the Chinese economy," noted Charles Yuan, partner at Shanghai-based Greenwoods Investment Management, at the summit.
The tightening up of liquidity in general, together with new, more restrictive rules for the asset management industry, mean the country's banking system no longer offers easy liquidity.
Issued in late April, the new regulations on asset management will discourage both banks and asset managers from pouring money into instruments with more opaque structures.
Specifically, banks will be prevented from providing “channel services”, which help makers of other investment vehicles bypass regulations; asset management firms, meanwhile, will not be allowed to launch products in which the underlying assets are bank credits.
“Banks became very cautious starting this year, they are in wait-and-see mood,” Yuan said. “We do not expect any banks to pour their customers’ money into private equity" in the immediate future.
VALUATION, EXIT WORRIES
The surge in private equity investment in recent years has had another consequence – stretched valuations.
“Over the last few weeks, multiple people told me ‘if you don’t raise at least $200m in series-A, you won’t make it’,” Nisa Leung, managing partner at venture capital firm Qiming Venture Partners, said at the summit. “That is dangerous.”
“Right now, I think the valuation is crazy in a lot of sectors, we must be very cautious,” Leung said, adding that her fund had walked away from multiple internet-related deals, which it considered too expensive.
With no sign of a correction in valuations and investors expecting a further squeeze on liquidity, funds trying to raise money in renminbi now face a struggle.
“The timing is bad for the funds that are in the process of fundraising, and the situation may not improve — at least not in the foreseeable future,” said Han Zhang, managing director at the fund of funds arm of Oriza Holdings.
Meanwhile private equity funds face pressure on the exit side, where the range of options is dwindling as regulators tighten up rules.
Over the past few years, Chinese private equity funds have been able to monetise investments in a range of ways, including listing on the A-share market in Shanghai or Shenzhen, or the lower-tier National Equities Exchange and Quotations, or via mergers and acquisitions.
“But now we see A-share IPO regulations become increasingly strict,” Zhang told the summit. Qiming's Leung said a specific problem was that listing candidates now had to show aggregated profit of Rmb60 million, double the previous level.
In spite of various hurdles in front of the renminbi private equity players, the market is learning and evolving fast, and there are ways out of the current dilemma.
Among the skills private equity managers and investors are stressing is their ability to add value, whether by post-investment management, specialist sector knowledge and a focused approach.
“Post-investment management is increasingly important in terms of adding value to the targets,” said Shawn Shi, managing director of Huagai Capital’s medical fund. “In the US, the contribution of post-investment management to the total value growth stands at about 50%; the number is between 10% and 20% in China.”
Shi also highlighted the benefits of sector specialisation. He argued that managers with a solid track record and investment experience in certain subsectors might find external factors such as liquidity and valuation less of a problem when fundraising.
Elsewhere, there are still signs of hope on the liquidity side.
“Some Chinese high-net-worth individuals have been diversifying to private equity from the listed market,” Yuanqi Zhao from Prosperity Investment said at the summit.
Greenwoods’ Charles Yuan said HNWI’s risk appetite had weakened given the recent policy backlash and more conservative market sentiment. But he expressed confidence as he observed that “the government-backed funds of funds are continuing to provide liquidity to this market".