Investors in these funds have typically focused on easy profits and quick exits, through IPOs. This is no longer as simple a strategy as it used to be.
Chinese private equity funds don’t look much like their counterparts in mature markets. For one thing, high-net-worth individuals and cash-rich companies are by far the largest proportion of limited partners (LPs) in these funds, rather than institutional investors. A 2011 report by the China Venture Capital Association estimated 87% of all LPs were individuals or companies, while financial institutions accounted for just 6.8%.
Consequently, LPs take a far more active role in managing their assets than their counterparts elsewhere, says Ning Jia, a professor at Tsinghua School of Management who researches China’s venture capital and private equity industry. LPs’ representatives on funds’ investment committees often have veto power over what assets the funds buy. A superabundance of new funds means investors can shop around.
Perhaps Chinese funds’ most interesting idiosyncrasy is their timeframe. In the boom years 2004-07 this was particularly marked: the median time to liquidation for a Chinese venture capital or private equity fund was 1.31 years, Professor Jia calculates, compared to 6.8 in the US. This period was also characterised by incredible returns: the median exit multiple at IPO (in terms of return on equity raised pre-floatation) was 26.4, compared to five in the US. (These figures no doubt suffer from survivorship bias: plenty of investments presumably returned nothing.)
Exit, pursued by a bear market
Sentiment cooled down after the crisis, but getting in and out quickly remained the aim, using IPOs to maximise quick returns. The launch in October 2009 of the ChiNext board of the Shenzhen Stock Exchange, specifically for new technology companies, played a big part in a PE/VC resurgence in 2010. Zero2IPO Research Center, a Chinese investment research company, called it a “beautiful fairy tale” for fund investors.
If it was a fairy tale, it wasn’t The Neverending Story. In the first quarter of 2012, Zero2IPO reports, the average book value return of VC/PE-backed companies that listed was 4.24 times, down from around eight in 2011 and nine in 2010. The ChiNext exit multiple was at a two-year low of 5.02. Financing raised has been decreasing steadily too. A massive rise in competition among new and fast-growing hi-tech companies hasn’t helped.
This suggests Chinese venture capital and private equity investors will have to rethink their strategies. One solution is changing the composition of LPs themselves (fewer get-rich-quick investors, more Warren Buffetts). Consolidation in funds of funds may help.
Crucially, though, more exit channels are necessary. Rather than immediately rushing to IPO, or focusing on investing in companies about to list, China’s funds need to diversify their investments and hold them longer, developing their intrinsic value. Then the likelihood would grow of exiting through strategic sales, helping industry consolidation. Of course, there are also thousands of foreign companies that would love to buy quality Chinese assets—but that would require a more thorough liberalisation of China’s investment rules.
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of The Economist Intelligence Unit Limited (EIU) or any other member of The Economist Group. The Economist Group (including the EIU) cannot accept any responsibility or liability for reliance by any person on this article or any of the information, opinions or conclusions set out in the article.
