SuperReturn China took place virtually on 11 May 2022, and I had the pleasure of speaking on the opening panel alongside three other industry veterans from Lemanik Asset Management, Capital Dynamics and StepStone Global, during which we discussed the private equity landscape in China for 2022 and beyond.
China is a major investment destination for most asset managers. Myself and my fellow panelists discussed how regulatory developments and geopolitical tensions were impacting investor allocations, the most appealing opportunities in the market despite the challenges, and how LPs and GPs should position themselves to navigate the coming months.
From my 10+ years as an LP and the past few years as a technologist partnering with leading regional and global firms, here are my main observations about China’s current private equity landscape and where it‘s headed:
Operational value creation, with tech-enabled measurement, is more important now than ever before.
China’s private equity market, like many others, has started and benefited from market arbitrage. Over the years, all sectors and the economy have grown, allowing private equity investors to enjoy handsome returns without much operational involvement. As the economy and businesses mature, it tests the GPs’ ability to provide more value, above and beyond just signing the deal.
Institutional LPs assess GP’s value creation ability across various dimensions, comparing investee company’s revenue growth, margin improvement, and de-leveraging capabilities during the holding period in addition to external factors such as multiple expansion and currency impact at entry vs. exit. During my LP days, we did nearly all the value creation analysis work ourselves; GPs contributed very little in this area, remaining reactive or simply unaware of the statistics despite the hard work that they put into their portfolio companies.
Nowadays (particularly post-pandemic) some of our GP clients have formed dedicated value creation teams and are exploring technology that will help them better measure the results and value drivers within their portfolios, and communicate returns to their LPs in a meaningful way. The ability to effectively collect, monitor and digest portfolio performance data, and transforming such data into insights has become extremely important. It helps GPs keep their LPs informed and demonstrates their track records with data-backed statistics – which ultimately helps them fundraise successfully from both existing and new investors.
ESG is changing from a nice-to-have to a must-have, across both LPs and GPs.
ESG has been a major topic amongst international investors for many years, even as far back as 2008. At the time, very few Asia-based GPs were aware of ESG – it was purely a box-ticking exercise. While ESG has not been a major part of investment strategy, many China-based GPs have been investing into green sectors such as technology, healthcare and clean energy (as compared to heavy manufacturing in the early days). Some of our GP clients in China and the region are starting to lay the groundwork in defining their targets and identifying appropriate success metrics to ensure they are achieving their ESG goals, benchmarking KPIs like job creation, emissions, avoiding consumption and electricity use in a more systematic and scalable way.
It helps that global regulatory bodies and institutional LPs are pushing for ESG to feature prominently on investors’ agendas. Global firms like KKR and Partners Group have raised dedicated Impact funds and some regional GPs in Asia also started to do so. GPs need to go into ESG with ownership and accountability – it’s no longer a passive investment where investors can just ride through macro growth and volatile stock prices. We believe that with the industry’s progressive mindset shift, ESG will eventually become crucial for Chinese GPs to be able to raise institutional capital in a sustainable way.
Downturns are cyclical; GPs who prepare well operationally will emerge stronger than ever.
Diversification of capital base has always been an important factor to ensure the longevity and competitive advantage of GPs. The short to mid-term shifting of global investor allocation away from China is inevitable given the geopolitical tensions and zero-Covid strategy. It is also hard to predict how long it will last before the international capital returns. However, we saw this over ten years ago after the global financial crisis, and if history has taught GPs anything, it is to 1) diversify capital base, 2) be transparent in fair allocation of investment opportunities, and 3) focus on improving the fundamentals, i.e. making good investments throughout the cycles.
We were also asked by the audience whether corporate VCs were gaining a competitive edge over traditional PE/VC funds. There are two factors at play; value creation and capital duration. We’ve touched on the growing importance of value creation above, but in the case of corporate VCs, capital duration is an important factor. While corporate VCs may appear to have fewer constraints on holding periods, they often have strings attached. In contrast, with more traditional PE/VC funds, there is a growing trend towards more flexible investment strategies (cross-over) and open-ended fund structures.
With ever-evolving fund structures and investment strategies, we’re seeing more COO roles and dedicated IR functions being established. An increasing number of firms, for example, are opting for evergreen fund structures, something that our software’s data engine is able to support. Recent technological advances have made it possible for GPs to ensure their portfolio, fund and LP data is well-organized regardless of the complexity. Best-in-class software should also enable 24/7 data accessibility, so GPs can better service domestic and overseas LPs with timely updates, answer ad hoc investor questions, and provide more accurate reporting and transparency in deal allocation.
Though current economic conditions in China seem particularly tough, Chinese GPs have proven their resilience time and time again. They are also extremely adaptive. Despite the headwinds they are facing with China’s rigorous zero-Covid policy, supply chain disruptions, regulatory restrictions and geopolitical tension, they will emerge strong from this cycle. Now is an excellent time for China-based GPs to take stock and assess their operational robustness – the savvy firms are ensuring their LP base is balanced, strengthening their Investor Relations team, and providing measurable values to their portfolio companies to stay ahead of the game.
by Jessie Juan
Co-Founder & Partner – Quantium