China's private equity market is facing some contrasting tensions. On the one hand local insurers and international institutional investors are becoming increasingly keen to buy into funds and deals. On the other, the number of private equity deals in China has fallen off a cliff, while local expertise is still lacking.
The aggregate value of private equity backed buyout deals dropped sharply to $11.6 billion last year when the new asset management rules were introduced, after having peaked at $34 billion in 2017 since 2014. Things got worse this year; total deal value stood at just $500 million as of May 31, according to Preqin.
The drop-off is largely down to the US-China trade tensions and the depreciation of the renminbi. At the same time, good deals in China are becoming more and more difficult to source, said Barry Tong, joint Asia Pacific head of transaction advisory services at Grant Thornton.
Despite the fall-off on volumes, institutional investors still seem keen to tap the China private equity market.
“The GDP slowdown in China does not pose any concern for private equity investments. The growth rate slows down but the quality goes better, so the private equity market in China will become healthier,” said Benjamin Deng, chief investment officer of China Pacific Insurance Corporation.
Moreover, China has just launched a science and technology innovation board, which can provide another exit channel for private equity assets.
Many institutional investors have the capability to evaluate the macroeconomic risks, and some private equity funds are countercyclical, which perform better when the economy is not doing well, Iris Pang, greater China economist at ING Bank, told AsianInvestor.
Outside China, the country’s private equity market is catching the attention of some regional asset owners – despite the ongoing trade tensions between the US and China. Australia’s Future Fund reportedly said in March that it planned to increase investments in Chinese technology start-ups, but heightened trade tensions are raising complications in the process. The SWF is one of the early stage investors of Didi Chuxing, now the Uber-equivalent in China.
There is now a greater focus on private equity in China among regional pension funds and sovereign wealth funds (SWFs), said Elliott Shadforth, wealth and asset management leader for Asia Pacific at advisory firm EY.
“It’s fair to say 2019 has some challenges for investment, but if you look at the short term in the last two to three years and what people look for in the next two to three years, we expect an increase in allocation in China’s private equity,” he told AsianInvestor.
RISKS AND CONCERNS
While interest in Chinese private equity is broadening, some financial experts say the insurers should avoid investing too much money in the asset class.
“Private equity funds are not credit positive because they have higher risks. They are not listed in the [public] market so if [investors] want to trade it, they are concerned about liquidity,” Stella Ng, director of insurance at Fitch Ratings, told AsianInvestor.
Liquidity is a key requirements of the asset liability management rules introduced early last year. As a result insurers must be more concerned about their cashflow mismatch risks, Ng said.
In addition, CBIRC looks set to finalise plans for a new phase of its China Risk-Oriented Solvency System (C-Ross) by mid-2020. Details of the solvency regime are yet to be concluded, but it looks likely to raise insurers’ capital charge for private equity from today’s 28%, she said.
On the other hand, although Chinese insurers are increasingly building out their in-house expertise on private equity investments, most will probably continue to rely on external managers and invest in private equity funds as limited partners. It will likely take some time before insurers can be as proficient in the asset class as external private equity fund managers.
Fund houses have sophisticated investment and incentivisation mechanisms and market resources to find deals – something that insurers lack, said the chief investment officer of a joint venture insurer based in China.
But finding good private equity fund partners isn’t easy. The top 10% of Chinese private equity firms typically generate 90% of the alpha, according to the joint-venture insurer CIO. That makes picking good investment managers especially crucial to capture promising returns.
One problem in the private equity market in China is the fund sizes are generally small and there are not many capable large managers, Asset Management Association of China (AMAC) said in the private equity and venture capital fund report released in early June this year.
In 2017, over 50% of the newly registered private equity funds had a fundraising scale of less than Rmb50 million; only 1.3% could raise over Rmb3 billion, according to the report.
Moreover, the regulatory framework on private equity is not comprehensive enough, as it does not have specific rules targeting the funds’ investments in different industries. Private equity fund’s post-investment management and value creating abilities also have to be further strengthened, as some funds have low creditability, weak risk control abilities and illegal operations, the report pointed out.
Private equity can help to diversify financial market and market needs no matter whether the economy is doing well or not, but regulatory oversight of such funds is important, ING’s Pang said.
It’s likely that Chinese insurers will keep allocating more resources to private equity. But in doing so they need to monitor the liquidity risk and potential change in capital charge under the looming phase of C-ross, among other regulations.
While some will commit more resources to build their internal expertise, most will likely partner with external managers. But there is a relatively thin field of talent, so asset owners will have to conduct rigorous research and due diligence to find the best managers, especially when the regulatory framework covering the private equity market isn’t fully mature.
Private equity is a promising field, but it contains many pitfalls. The challenge for China’s insurers will be to avoid as many as possible.
This story was adapted from a feature that originally appeared in AsianInvestor Summer 2019 edition.
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