China’s popularity as an investment destination has faded, but GPs active in the market highlight attractive entry valuations and an overblown downturn story. Still, exits remain a quandary

China will enter the year of the dragon clouded by uncertainty. The International Money Fund expects growth to moderate from 5.4% in 2023 to 4.6% in 2024 amid weakness in the property market and subdued external demand. It will decline to about 3.5% over the next five years as productivity drops and the country’s population ages.

Private equity firms that have spent much of the past two decades investing in proxies for the rise of the Chinese consumer are now witnessing a weakening in consumer sentiment. Some form of government support is anticipated. In the meantime, they are keeping a wary eye on potential destabilisers from local government debt to inflation to US-China tensions.

“Geopolitical concerns will likely continue and take centre stage in 2024 what with presidential elections in Taiwan and the US. The fundraising environment is highly dependent on the outcomes of those events,” said Brian Lee, general counsel at FountainVest Partners.

Commitments to US dollar-denominated funds stand at USD 11.5bn, less than half the total for 2022, as investors question whether China’s risk-return makes sense. LPs based in North America have been especially reticent. Renminbi fundraising is up 35% at USD 52.6bn, although government guidance vehicles account for a large portion of that, according to AVCJ Research.

Managers with dry powder are deploying it cautiously, recognising both the uncertainties around investment and the need to conserve capital in adverse conditions for fundraising. Investment is down 52% year-on-year at USD 38.4bn, yet there is widespread belief that bargains are available for those willing to pull the trigger.

“We see it as a golden opportunity right now in terms of finding great assets at reasonable valuations and being able to negotiate terms that you would unlikely have been able to negotiate 2-3 years ago,” said Philip Hu, a founding member and managing director at Primavera Capital Group.

Finding value

Perceptions of value vary by sector. Julian Wolhardt, CEO of DCP Capital, believes daily necessities are attractive within the consumer space because they are less impacted by softer purchasing power. Mengyang Yang, head of Hong Kong private equity at CICC Capital, identified “a considerable divergence between valuation and value” in biomedicine following price corrections in healthcare.

CICC is broadly positive about the prospects for innovative drugs, carbon neutrality, new materials, high-end manufacturing, digital economy, and new forms of consumption.

Carbon neutrality – or energy transition – remains a popular area given China’s needs in this area and the government’s willingness to provide policy support. Investment in cleantech and renewables is down by more than half in 2023 at USD 4.6bn, but it still accounts for 12% of total deal volume. In the five years to 2021, it averaged 4%.

Conrad Tsang, founder and chairman at Strategic Year Holdings, noted that climate change is fraught with political sensitivities. China is the largest provider of key materials used in the likes of electric vehicle batteries and solar cells – and so green-tech has emerged as one of numerous areas where international companies are looking to diversify their supply chains.

“People woke up in the first wave of COVID in 2020. When China shut down, they realised the importance of having their own supply chain,” Tsang said. “And I think it’s going to continue.”

Nevertheless, China remains an important cog in manufacturing ecosystems. Jensen Huang, CEO of Nvidia, recently noted that his firm sources more than 3,500 components globally, with 90% of certain products comprising parts outside the US and Europe. He thinks it will take the US 20 years to achieve independence from China in semiconductors.

Investors are reluctant to consider export-related opportunities given the risks presented by deglobalisation. Addressing domestic demand remains a core focus, but increasingly there is an international angle to this – backing foreign companies that can expand into China and helping successful local players enter overseas markets.

DCP started 2023 by committing USD 175m to Jamieson Wellness, a listed Canadian producer of health and wellness products that wants to build a China presence. It ended the year with the acquisition of Cargill’s China poultry business. Due to weak demand and pricing challenges in the local market, global sales opportunities are being explored, including the US, according to Wolhardt.

Most of DCP’s portfolio companies could be considered China nexus – or China relevant – in some way. “China nexus plays a significant role in deal-making due to limited growth in China,” he added.

The Cargill carve-out is regarded as part of a broader trend whereby foreign multinationals are offloading their China businesses, thereby providing more buyouts for private equity. Geopolitics is often a factor, but not necessarily the only one. Cargill’s China poultry operation was underperforming, so the shifting political landscape may have accelerated a decision to sell.

“As multinationals divest their China operations, various forms may emerge, potentially leading to more control deal opportunities,” said Yang of CICC.

Wolhardt was more forthright, noting that the number of control transactions in the market had doubled in the past four months. Some fit the carve-out profile; others are domestic companies that have run into trouble.

Looking for liquidity

Stock market listings are a logical liquidity event for such investments. Approximately 180 private equity-backed Chinese companies have raised USD 41.4bn between them in 2023. China is responsible for 90% of the proceeds region-wide, although the vast majority is from IPOs on mainland exchanges. Investors describe the local listing process as slow and highly selective.

Realised exits, as opposed to liquidity events, average USD 26.2bn for the five years through 2021. They plunged to USD 6.9bn in 2022 and are around USD 4.4bn in 2023, the lowest level in more than a decade. This comes on the back of weak trade sale and sponsor-to-sponsor activity, and few IPOs in international markets.

Managers are looking to generate realisations through other channels – “Finding a way to create distributions from a position of strength is much more preferable than exiting from a position of weakness,” Hu of Primavera noted – with continuation funds high on the agenda. The enduring challenge is establishing a valuation that is acceptable to buyers and sellers.

Yang of CICC said that secondary investors are looking at GP-led deals but the volume “seems different than expected.” Meanwhile, the rise of control transactions may create more possibilities in terms of sales to strategic investors, but the concept remains largely unproven.

There will always be demand for high-quality assets in robust industries; the question is whether private equity firms need to sell – rather than wait for market conditions, and valuations, to improve – and whether portfolio companies need additional funding.

“I am not worried about exits,” said Wolhardt of DCP, adding that in cases where investments are generating dividend streams, there isn’t much pressure. “I am more worried about the capital deployment side.”

Those who can be patient will be. According to Yang of CICC, fiscal stimulus efforts in 2024 may help China’s economy move from “endogenous bottom finding” to “exogenous recovery.” There will be no jump-start effect; she expects the recovery to accelerate gradually over the year.

Speaking at a recent investor conference, Weijian Shan, executive chairman and co-founder of PAG, suggested it would take a couple of years of policy stability and concrete policy support for the private sector to fully regain its confidence. PAG’s China investment thesis remains rooted in backing businesses that cater to private consumption.

Shan played down concerns about inflation and an unsustainable debt burden and emphasized the country’s growth potential in green-tech and digital economy, its emergence as a leading global player in technology, the resilience of its manufacturing supply chain, and the government’s ability to leverage polity in the pursuit of economic targets.

“China’s economic fundamentals are sound; its government has ample policy space to tackle its current economic slowdown; and its industrial development has positioned it well for the future. All of this is to say that China’s growth, despite the naysayers, will likely continue for the foreseeable future,” Shan added.