Trade wars, geopolitical tensions and Chinese government interventions have raised the risk of investing in China. High-net-worth investors (HNWI) may thus want to have less
exposure to Chinese companies with dealings in foreign markets or sectors out of favour with government policies.
Instead, HNWI may want to keep or increase exposure to Chinese private companies because most of them are suppliers to consumers in domestic markets and have few dealings in foreign markets or unsupported sectors.
Chinese private companies are unlisted on stock exchanges and make up the asset class known as Chinese private equity (CPE).
One way to invest is through investment funds with diversified CPE portfolios. Over the past five years, close to three dozen such funds were launched by North American and European financial institutions such as UBS Group, BlackRock Inc. and Allianz SE. Many Chinese firms offer the funds, too.
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Why invest in Chinese private equity?
For decades, the Communist Party of China poured money into building up infrastructure and promoting export-led growth. But now they want to generate a more balanced growth trajectory by encouraging domestic consumption until it approaches a percentage of GDP similar to other developed countries.
That policy goal provides a tailwind for CPE.
“Previously, the economy was largely driven by government investment but now consumption has a much more important role,” Jean Salata, CEO of Baring Private Equity Asia, told consulting firm McKinsey & Co. last August. “That’s a long-term theme that will continue to play out: growth in consumption, growth in the middle class.”
“The China-U.S. trade dispute and COVID-19 have accelerated some long-term trends,” adds K.C. Kung, managing partner of a CPE fund called Nexus Point. “For example, domestic consumption is in play because you have no idea what may happen with international trade, and the government wants to boost consumption for growth.”
CPE funds tend to have significant exposure to domestic markets and consumer expenditures. For example, the positions held in Kung’s CPE fund include a fast-food chain (Burger King Taiwan), a manufacturer of plastic packaging for cosmetics (Sanying Packaging) and a provider of homecare medical devices (Jumao).
The Chinese private-equity market
The CPE market is growing in leaps and bounds. From 2011, it soared at an average annual clip of 29 per cent to land at US$134 billion in 2018, according to estimates from alternative-asset data provider Preqin.
Although this makes China the third-largest private-equity market, there is a lot more room for expansion: CPE represents just 0.4 per cent of China’s GDP compared to 2.4 per cent in the U.S. and 1.6 per cent in the EU.
Like private equity elsewhere, CPE has emerged as an asset class with superior returns. According to Bain and Co.’s Asia-Pacific Private Equity 2021 report in March, Asian returns “outperformed the region’s public markets by at least 3 percentage points across 5-, 10-, and 20-year horizons.”
The year 2020 was particularly stellar for CPE funds: China’s Securities Daily found that the average return exceeded 30 per cent.
“Private-equity funds have learned how to work closely with companies long controlled by aging founders … helping them finance modernization drives,” observes Winston Ma, the author of The Digital War and a law professor who formerly was a managing director with the China Investment Corporation (a sovereign wealth fund).
Like other private-equity funds, CPE funds charge an annual fee of 2 per cent and take 20-per-cent of gains above a threshold. The funds are not usually listed on public exchanges. Minimum investment requirements are US$200,000 and upward and investors need to commit capital for several years.
“We are observing an average valuation of 16 times EBITDA [earnings before interest, taxes, depreciation and amortization] in enterprise valuation for China deals,” notes John Prince, CEO of Respada, a family-office platform.
The median EBITDA multiple was in single digits a decade ago, according to a McKinsey & Co. report released in April. For the risk averse, such high valuations suggest restraint when weighting CPE in portfolios. Some exposure may still be worthwhile, however, thanks to China’s high growth rate.
CPE funds are also shifting from minority stakes to control stakes, which enable them to add alpha through operational improvements and timing of exits.
Eric Olson, CIO of Olson Capital Management, also favours local Chinese companies. In his view: “China’s recent actions around Didi’s listing in the U.S. shows that the U.S. and China remain at war economically; the campaign against tech mogul Jack Ma further illustrates the risks of investing in sectors under government scrutiny.”
When seeking exposure to China’s high growth rate, there is less risk when taking positions in sectors favoured by government. This points to CPE. Such companies are more likely to be engaged in the production of goods and services for domestic consumption, an aggregate the Chinese government wants to boost. The domestic market is also a sector less exposed to trade wars and geopolitical risks.