The rush into private equity in China is destabilizing the market and could result in lower returns, smaller inflows and fewer managers staying in business.
The explosion of investor interest and capital flows into China funds caused a growing number of managers to set up shop in China to get a piece of the action, as private equity managers closed 109 China-focused funds worth a total of $30.9 billion in 2011, up from just 46 closings worth $6.4 billion in 2009, according to research firm Preqin Ltd.
However, competition for investing in new deals and challenges to exiting other deals could cause a thinning of the manager herd, as evidenced by Preqin's data that show year-to-date closings as of Oct. 9 were just one-third of last year's total.
“The expectation is there will be a correction in China and we will see a weeding out of the (managers) attempting to set up shop based on investor interest,” said Luba Nikulina, London-based senior investment consultant and global head of private markets at Towers Watson & Co.
Ms. Nikulina said there are skilled private equity managers in China, but an overheated market is affecting even those managers' abilities to do deals.
Preqin data show that private equity investments in Chinese companies are “likely to be near record levels” in 2012, said Manuel Carvalho, manager, private equity deals, at Preqin in London. Private equity managers had invested $7.6 billion in companies in China as of Oct. 9, near the total of $7.5 billion for 2011 and on track to top the $8.5 billion record set in 2007.
However, that's not to say all of those investments were good moves.
“It's fair to say a lot of companies out there that are receiving capital aren't necessarily the greatest companies that you might want to be putting money into,” said Benjamin Cavender, associate principal at China Market Research Group, Shanghai, because there's more money chasing fewer good opportunities.
Meanwhile, exits from private company investments via initial public offerings — the predominant way in which managers retrieve capital from China investments — have been crimped by tougher regulation, lower valuations and the lack of investor interest for Chinese companies listing on exchanges in other markets.
Private equity funds used IPOs to retrieve $6.1 billion of investor capital in China as of Oct. 9, according to Preqin. That approximately matches 2011's total, but is a steep drop from private equity-backed IPOs worth $10 billion seen in 2010.
Sanjay Mistry, director for private equity funds of funds and private debt at Mercer in London, said lower valuations — specifically a narrowing of the valuation spread between public and private companies — have tamed IPO activity in China.
“Exits are an issue, as the market still remains relatively thin,” Mr. Mistry said in an e-mail. “The issue is that even if the entry case appears attractive, new investors will be thinking twice about investing if capital isn't being returned, and the early movers could find themselves with no new capital to allocate.”
Restricted exits will create a bottleneck effect and “ultimately (become) a big impediment to the continued expansion of capital raised for investing in China,” according a report from specialist investment bank China First Capital.
CFC estimates that private equity companies have invested $50 billion in private companies with another $50 billion raised but not yet invested. “That is enough to finance investment in around 6,500 Chinese companies, since average investment size remains around $15 million,” according to the report.
The report adds that “there is little to no investor interest” from U.S. investors in private Chinese companies looking to go public in America.
The result: “A rather steep downward slide” is expected in returns from China funds, according to the report. “Until recently, the best-performing PE firms active in China could achieve annual (internal rates of return) of over 50%. ... But, it may prove difficult for these firms to do as well with new money as they did with the old.”
This is supported by Preqin data, which show median IRRs as of Dec. 31 peaking at 30.1% on 2001 vintage funds while falling below 5% on 2009 vintage funds.
Experts point out that investment opportunities in China remain more attractive than those in other parts of the world, thanks in large part to seemingly never-ending economic growth of 7% or more in the world's second-largest economy.
“The overall size of the opportunity for private equity in China remains large, but as in all private markets, manager selection is critical given most investors will only be looking to invest in a handful of the many fund options open to them,” Mr. Mistry said.
Manager proliferation is making manager selection in the Chinese market more important than ever before, according to Antoine Drean, founder and CEO of online private equity marketplace Palico SAS, Paris.
“The best Chinese private equity (managers) — those with real sourcing and operational abilities — continue to report high levels of both purchase and exit activity,” Mr. Drean said in an e-mail. “Less-experienced private equity managers ... have hit a wall. There are a lot of inexperienced managers in China, and that is posing problems for investors in their funds.”
Towers Watson's clients haven't reduced allocations to China, but they have held off making investments, Ms. Nikulina said. “We are very cautious in this market, and we are looking for the right time and the right partner (for our clients) to invest with.”
Towers Watson manages about $10 billion in discretionary accounts. Ms. Nikulina wouldn't discuss individual managers. But sources cited Affinity Equity Partners (HK) Ltd., Baring Private Equity Asia, GGV Capital and Hony Capital (Beijing) Co. Ltd. as among the top picks in China.
Experts note the private equity market in China is maturing, with companies looking to build on past success by rising to global standards of corporate governance. “It's not just a cash grab anymore, they're also looking to private equity owners on governance issues as well,” China Market Research Group's Mr. Cavender said.
Ms. Nikulina said improved governance won't necessarily help with exit issues, but there is a link between governance and exits: “I can say with certainty it makes a company better,” she said. n
This article originally appeared in the October 15, 2012 print issue as, "Rush to invest in China could backfire".