Abstract: The private equity sector in China has been playing a critical role financing technological innovation and facilitating the country’s low-carbon transition, new infrastructure projects and the dual circulation drive. Under new circumstances, China should press ahead with financial opening and work to attract global capital to boost the sound growth of private equity, so that it can play its due part driving high-quality financial development.
Good morning, ladies and gentlemen! It’s my pleasure to participate in today’s 2021 Global PE Forum.
Amid mounting uncertainties under the COVID-19 pandemic’s blow, China is going through tremendous changes unseen in a century. Today I would like to put the development of private equity (PE) funds in China in the context of the country’s pursuit of dual circulation, carbon neutrality and high-quality development, and share some of my thoughts.
I. THE PE SECTOR HAS BECOME AN IMPORTANT SUPPLIER OF LONG-TERM CAPITAL IN CHINA
1. The PE sector has maintained its momentum despite the pandemic’s blow
Over the past year and a half, the global monetary and financial environment has been reshaped by the pandemic. The intensified competition between China and the United States (U.S.) has posed new challenges to the capital market. The world economy has plunged into a post-pandemic dilemma where there is abundant short-term liquidity and record highs in the financial market especially the stock market, but a shortage of long-term capital. This is what the economists call the “global liquidity trap”. According to estimates, the United Nations’ SDG goals face a financing gap of 2.5 trillion dollars, while in 2020 alone global central banks have seen their balance sheets blow by a whopping 9 trillion dollars. With most of these funds invested in government bonds, the financial market has been flooded with short-term liquidities. At the meantime, there is a severe lack of long-term investment that is indispensable to reviving the global economy and addressing some of the most pressing challenges today including unemployment, inequality and climate change.
Despite the continuous Covid resurgence around the world, China is well on its way toward economic recovery, with the PE industry keeping up desirable growth.
According to the data of Asset Management Association of China (AMAC), as of the end of 2020, China had 29,400 PE funds, including Funds of Funds (FOFs), totaling 9.87 trillion yuan which was 11.3% higher than in 2019. The year of 2020 witnessed 11,400 new investment cases amounting to 1.18 trillion yuan, a year-on-year growth of 4.4% which put an end to the continuous decline in the previous two years. 6,135 PE funds concluded in 2020, amounting to 652.1 billion yuan, with an average investment horizon of 39.9 months.
Regarding venture capital (VC) funds, as of the end of 2020, China recorded 10,400 registered VC funds that totaled 1.69 trillion yuan, representing a 39.8% of growth compared with the end of 2019. In 2020 there were 10,300 new investment cases amounting to 271.5 billion yuan, representing a remarkable year-on-year growth of 77%. Throughout 2020, 10,700 investment projects amounting to 374.8 billion yuan were terminated with an average investment horizon of 41.69 months.
That the VC and PE funds in China have maintained desirable growth amid the pandemic indicates that innovation and entrepreneurship activities in China have remained vibrant despite Covid’s blow.
2. Regulatory support is necessary for the PE sector’s sound development
Ever since 2013 when PE funds were put under the regulation of China Securities Regulatory Commission (CSRC), they have played an important part promoting social capital formation, improving the share of direct financing, boosting technological innovation, upgrading investor structure and supporting the real economy, among others. But at the same time, many of the PE funds engage in irregularities such as explicit and implicit public offering, collectivized operation, capital pool operation, tunneling, and guaranteeing one’s own financing.
In recent years, China has stepped up to clean up disqualified fund managers. Since 2016, a total of 16,500 non-compliant PE funds have been deregistered by the AMAC, among which 2,500 were voluntary deregistration, 12,200 were because they failed to register their first fund for the 6 months after establishment, and around 1,700 were cleared up because of irregularities, abnormal operation or loss of contact, etc.
With an array of regulatory measures including disciplinary oversights and disclosing funds in abnormal operation, there has been significant improvement in the quality of the PE sector. On January 8, 2021, the CSRC released Regulations on Strengthening the Supervision of Private Equity Investment Funds which strengthened disciplines over the industry with profound implications for its development.
II. PE HAS PLAYED A CRITICAL ROLE BOOSTING TECHNOLOGICAL INNOVATION AMID CHINA’S CARBON NEUTRALITY, NEW INFRASTRUCTURE AND DUAL CIRCULATION DRIVES
In 2020, China implemented expansionary policies to counter the pandemic’s blow; however, going forward, in pursuit of high-quality development and common prosperity, it’s important to turn to steadier structural policies.
Since the trade war in 2018, China and the U.S. had been in ongoing tensions. The U.S. has kept pressuring key high-tech industries in China. With the restrictions, it’s very hard for these industries to find a way out drawing on the market force alone; the government has to play its due role supporting high-tech industries, and boosting the development of funds would be a good start. In a long-term vision, even without the trade war, China has to boost its high-tech industry in order to overcome the middle-income trap. However, it would be hard for high-end sectors to advance without private equity funds, venture capital funds or a well-functioning capital market, and technological advances could hardly materialize into productivity without enough capital.
1. VC and PE funds play an important role boosting new infrastructures and dual circulation
At the end of last year, Chinese Vice Premiere Liu He said in an article on the background, implications and roadmaps of dual circulation that China should “deepen reforms, step up opening and promote technological innovation and industrial upgrade,” and “make structural adjustments to the financial system and improve the weight of direct financing.” VC and PE funds have become the most important source of financing for technological innovations in China. Data suggests that over 80% of the listed companies in China’s STAR market have the support of VC and PE funds behind their back.
Going forward, China needs to give bigger play to VC and PE funds in boosting industrial upgrade, addressing weak links along the supply chain and speeding up industry convergence and agglomeration. Specifically, new infrastructure is expected to become a new engine driving economic growth. Among the most promising sectors are 5G infrastructure, extra-high voltage (EHV) equipment, intercity high-speech railway, urban railway, charging posts for new energy vehicles, big data centers, AI and industrial internet. There are many things VC and PE funds can do in these sectors with the government to promote their development.
2. PE funds are critical in financing breakthroughs of high-tech bottlenecks
As of the end of 2020, FOFs in China totaled 2.78 trillion yuan, including 2.2 trillion which were government-led and the rest, market-based. The second half of 2020 witnessed continuous emergence of new large government-led funds, including 88.5 billion yuan of funds for green development, 50 billion yuan for cultural industry development and 70.7 billion yuan for state-owned enterprise reforms. The three national-level FOFs added up to 209.2 billion yuan. Most of these government-led funds are set up by the Chinese government at different levels and are usually worth billions. Funds at such magnitude are capable of guiding deeper and wider industrial upgrade and regional economic development. The most typical example is the China Integrated Circuit Industry Investment Fund established in 2014. Only with the long-term, stable and low-cost capital support from such large funds can the semiconductor industry in China catches up with or even overtakes its global competitors.
3. VC and PE funds are important to China’s carbon reduction and neutrality
Over the past decade or so, ESG investment has gained great momentum, and its stronger risk resistance and higher return have been proved by both studies and practice. The market’s attitude toward ESG investment has also changed from “why” to “why not”. Long-term investors like sovereign wealth funds, pensions, insurance funds and family offices have shown strong preference for ESG investment, and these are exactly the ones behind private equities’ backs.
The increasing interest in ESG investment of private equity funds is also owed to shifts in thinking, especially in the following three aspects:
First, business goal. The traditional western definition of business goal as “maximizing profits and thus shareholders’ interests” does not fit into the current socioeconomic realities. Businesses are increasingly responsible for not only shareholders, but also stakeholders at large including employees, customers, suppliers and communities. They need to balance profitability and social responsibility.
Second, assessment of a business’s value. Going forward, referring only to financial statements to value a company will increase the exposure to “black swans”. According to statistics, back in 1975, 83% of the market value of S&P 500 constituents was owed to tangible assets, while in 2015, 84% of the market value came from intangible assets, or “soft powers”, like reputation, brand, stakeholder trust, risk management and sustainability. Companies with good ESG performance usually run more stable with better reputation, and thus have higher value in the long run.
Third, revisiting the Modern Portfolio Theory. The Theory that dates back to the 1950s is the cornerstone of any study of investment, sketching the famous efficient frontier which presents the relationship between investment risks and returns. Investment portfolios on this curve are deemed most efficient, reaping the highest possible returns given a certain level of risks, or minimizing the risks given a certain level of returns. However, with increasing focus on environmental and social issues worldwide, scholars have begun to revisit the theory. Mindful of the absence of ESG concerns in the model, they have tried to add the factor as the third dimension in investment portfolios. There have been attempts to sketch an “efficient impact frontier” that incorporates impact investment data.
China’s endeavor toward carbon peaking and neutrality is part of the global effort to cope with climate change and an important step in its pursuit of high-quality development and building a shared future for mankind. Realizing the 2030/60 goals is a systematic endeavor. Carbon neutrality is not all about energy transition even though this is the focus of efforts; instead, it involves various areas in the socio-economy including transportation, industry and construction.
Going forward, private equity funds could step up financing related sectors including new energy, energy conservation, electric power, circular economy, traditional energy upgrade, and carbon technologies and carbon markets. They could also, in their post-investment management, provide necessary resources for investee companies to promote their green transition.
III. FUNDRAISING, INVESTMENT, MANAGEMENT AND EXITS OF PRIVATE EQUITY FUNDS IN CHINA STILL INVOLVE IRREGULARITIES; CHINA SHOULD DRAW FROM GLOBAL EXPERIENCE
1. Fundraising: Lack of long-term capital
High-tech companies usually go through three stages of development. First is the “0-to-1” stage, where they develop new technologies. Financing this stage require the support from the government, the companies’ own R&D inputs, and investments from seed funds and angel funds. Second is the “1-to-100” stage where the new technologies materialize into production forces and patents. It’s important to establish small- and micro-sized enterprises and various technological innovation centers, incubation centers and accelerators to serve the materialization process. Third is the “100-to-million” stage, the stage of massive production. Sources of financing at this stage include follow-up funds from equity investment institutions, IPOs, mergers and acquisitions, and bank loans.
During the first two stages, businesses usually find it hard to acquire bank loans. Thus, VC and PE funds should provide them with long-term capital to support their growth. But in reality, some of these funds issue fixed-return stocks which are de-facto debts with leveraged capital or even illegally collected money, and that could harm the sound development of the sector.
China could learn from international experience in coping with the lack of long-term VC and PE capital. Take the U.S. for example. As of the end of 2020, the U.S. had pension funds amounting to 37 trillion dollars in total. Open data suggests that in 2018, 43% of the pension funds in the U.S. went to the equity market, in which 25% were invested in private funds. In comparison, by the end of 2020, China had private equity funds of 9.42 trillion yuan, and 0.6% or 53.523 billion yuan were contributed by pension and social security funds; total venture capital funds stood at 1.1 trillion yuan, and 0.4% or 5.711 billion yuan were contributed by pension and social security funds. In comparison, China still has tremendous underused pension and social security funds.
2. Investment: Some of the companies are interested in nothing but profiteering; PE and VC funds need to enhance their professional competence.
There used to be some companies in China that had no interest in creating value at all; their sole purpose of operation was to profiteer. These companies usually lobbied follow-up investors who ended up buying into their slides and stories without doing due diligence and getting duped. Due diligence is critical for a fund planning on investing in technological innovation projects. Here I propose some suggestions:
First, focus on the actual state of operation of the investee company. Financial data that is above industrial average level without any plausible explanation such as a special commercial model or exceptionally efficient management could indicate risks.
Second, do field research, and talk to the employees. Many investors only talk to senior executives when evaluating investment projects, but this is not the best way to know how exactly the company is doing. Talk to its employees instead.
Third, understand the investee’s competitors, clients and partners. Looking at the competitors will give a clearer idea of the pros and cons of an investment project. The quality of clients and partners is a good indicator of the investee’s performance, and review of related contracts could also help identify frauds if any.
3. Exit: VC and PE funds should be more patient with company growth
Difficult exit has always been a big problem troubling the PE sector in China. In December 2020, the CSRC revived the sector with new possibilities by approving trials for equity investment and venture capital share transfers at Beijing Equity Trading Center. The trial for secondary fund share transfer will serve as a good example for similar efforts across the country.
The development of secondary funds will help expand channels for the exit of equity investments and venture capitals, forging a sound ecosystem with smooth flow of financial and industrial capital across the entire lifecycle of private equity investment.
IV. OPENING WIDER TO THE WORLD TO ATTRACT MORE INTERNATIONAL INVESTMENT IN CHINA
1. Chinese and US regulators should stay focused and enhance communications
In recent two years, the US has been targeting China financially by frequently using the politicized “Executive Order”, or putting China’s key industries, target companies, or institutions on the Entity List and imposing asset controls, or issuing medium to long term sanctions that prohibit China’s access to the US capital market for financing. Particularly, in last May, the US Senate passed unanimously the“The Holding Foreign Companies Accountable Act” that will force foreign companies listed in the US to be delisted if they fail to comply with requirement of additional disclosure for three years in a row. Immediately, the concern over China-US “financial decoupling” emerges again and the PE sector, especially US dollar funds, exacerbates such concern.
We should realize that in the context of great power competition between China and the US, data and financial security amount to national security. But the national policies taken by the US do not mean that China and the US are on the road to decoupling. The financial instruments adopted by the US government are simply the means for major power rivalry. For example, the US recently suspended the IPO of China concept stocks, which pushes forward the “decoupling” between China and the US. But if the decoupling really happens, Chinese companies will no longer go public in the US. This will not only hurt the financing need of Chinese companies, but also make the US capital market lose a large group of good-performing companies, undermining the US’s influence and status as the global financial center. Thus the result will be a lose-lose scenario. Over the past years, the financial relations between China and the US have remained resilient. Regulators from the two sides should keep negotiating with each other on issues of mutual concern to achieve a win-win result.
2. The best investment opportunities are in China, which requires further opening up of China’s financial sector
In recent years, China’s financial sector has continued to open wider to the world. China has approved the entry of more than a hundred organizations like foreign-funded banks, insurance, securities, and payment and clearing organizations. The opening of China’s financial sector has kept improving its market attractiveness. Meanwhile, the participation of international organizations also brings vitality to the financial sector, which can help the sector realize a higher-level and healthier development.
On the other hand, since the globalization of the high-tech industrial chain is still an important trend, China’s tech industry cannot develop on its own. We need more global investment and work with the world to promote the development of China.
Ladies and Gentlemen! This year marks the beginning of China’s 14th Five-Year Plan and we are now at a historic moment when the world is undergoing great changes unseen in a century. Against this background, China will not slow down its development towards sustained growth nor stop upgrading the industry, and our resolve to open up the market will not falter. I hope that China’s PE sector will better play its role as a driving force that pushes forward the building of new development paradigm so as to help China’s economy take off!
This is the speech made by the author at the 2021 Global PE Forum held on September 5, 2021. This is translated by CF40 and not reviewed by the author himself. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations.
