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Hurdles Ahead for Private Equity Firms Investing in China – September 2015

by Jie Mei Tan

  • 17 Sep 2015
  • PE

It would not be too far from the truth to say that most, if not all, eyes are on China at present. The world's second largest economy is going through a phase of cyclical slowdown, trudging along at 7% GDP growth per year, noticeably shy of its historic double-digit peaks. Exports have also fallen, burdened by lacklustre global demand. Most troublingly, its stock markets are going through a turbulent phase, with share values diving by more than 40% since June. Although private equity is touted as an absolute return investment with little correlation to other traditional asset classes, private equity firms should still remain aware of the possible implications of these adverse conditions on their investment activities.

Preqin's Fund Manager Profiles platform currently tracks 848 private equity fund managers targeting the Chinese market, which collectively possess $327bn in dry powder at their disposal. Of this pool, slightly less than half (48%) are domestic firms headquartered in China, while the remaining 52% are based outside the country.

In light of the nation's economic slowdown and a global currency devaluation regime, Chinese policymakers have allowed the yuan to fall so as to help boost export competitiveness along with growth rates. This is worrying for foreign private equity managers which have raised or are planning to launch RMB-denominated China-focused vehicles, since deals and subsequent exits will be made in the weakening yuan. Firms have to acknowledge that returns from their China-focused funds may be diluted by foreign exchange losses.

Another significant concern for China-focused private equity firms is the ongoing equity rout and the ensuing freeze of IPOs by the Chinese Government in an attempt to assuage the stock market turmoil. As a result, GPs might have trouble liquidating their investments and returning money to LPs. This issue is especially pertinent for managers of buyout and growth vehicles, since IPOs are one of their core exit methods. According to Preqin’s data, a quarter of fund managers operating in China utilize the buyout strategy, while 52% target growth equity deals, hence the effects of the IPO freeze should be widely felt.

With reference to the J-curve effect, where the greatest share of cash returns to investors occurs in the later part of a fund’s lifespan – typically from year five onwards – we can estimate that firms managing China-focused funds with vintages 2005-2010 would be the hardest hit. Preqin’s Funds in Market online service tracks 268 such vehicles, which have raised a combined $60bn. In response to unfavorable IPO conditions, managers of these funds are likely to seek alternative exit routes, such as trade sales, secondary sales to other GPs or management buybacks.

Despite the challenging economic landscape faced by private equity firms investing in China, it is highly likely that the devaluation regime and IPO freeze will be only temporal policies. All in all, given the positive longer term prospects of the Chinese private equity market, we can expect GPs to eventually ride out these interim rough patches, and sustain China’s momentum going forward.

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