The COVID-19 pandemic has caused vast public health and economic disruptions, and forced many investors to focus on the short-term. Meanwhile, geopolitical tensions have introduced uncertainty about the flow of capital into China-focused private equity (PE) funds. In light of these developments, there is a danger of missing the long-term picture, which is that China is on the verge of a golden age of PE investments. Indeed, it is my belief that China is set to become the world’s largest PE market by 2045. This may seem a long way off, but the factors propelling the growth of China’s PE market are already in play, and investors who act now to expand their capabilities will be much better positioned to benefit when they coalesce. My prediction that China will become the world’s largest PE market in the next 25 years is based on four underlying trends:
1. Sustained macroeconomic growth will support PE market expansion
Over the next decade, the International Monetary Fund expects China to become the world’s largest economy, surpassing the US in terms of nominal GDP. In 2019, the dollar value of China’s economic output was already the second-highest in the world, at $14.3 trillion, almost three times that of Japan, and far outstripping Germany, India, and the UK. China is also the engine of global GDP growth, contributing 37.9% in 2019, and remains the only major economy on track to expand in 2020 amid the pandemic-induced global downturn.
China’s PE market has enjoyed a similarly impressive arc of rapid, consistent growth. From 2011 to 2018, China’s PE market expanded from $22 billion to $134 billion at a CAGR of 29%, according to Preqin, a provider of financial data on the alternative asset market. For comparison, Dealogic data puts PE market deal value in the US at $469 billion in 2019. Despite being a relatively late developer, China is now the world’s third-largest PE market, deploying approximately $78 billion of capital in 2019. Having said that, the total value of China’s PE market still only accounts for 0.4% of GDP. This is at the very low end of market penetration when compared with rates of 2.4% in the US, and 1.6% in the EU, suggesting that there is considerable scope for further growth.
2. The private sector is booming, and provides a fertile seedbed for PE investments
PE activity in China is driven by a vibrant private sector in which the number of enterprises almost tripled to 15.6 million between 2013 to 2018. This proliferation of private companies acts as a seedbed for PE investments of all types – minority growth, control, and venture capital (VC).
The sheer size of China’s economy, coupled with supportive government policies (currently in the shape of the “dual circulation” strategy to achieve balanced growth by boosting domestic consumption and innovation), will give rise to a healthy pipeline of companies seeking PE growth capital. What’s more, these companies can scale remarkably quickly within China, thanks to a mature industrial and commercial ecosystem capable of taking products through R&D and design to manufacturing, sales, marketing and distribution. As discussed in a previous article (3 Reasons Control Deals are Taking Off in China’s Private Equity Market), the market for control transactions in China’s PE market is also set to rapidly expand as an aging generation of company founders seek to cede control, and access to acquisition financing improves.
The runway is equally appealing for VC. As it stands, China is the world’s second-largest VC market, and home to more than half of the world’s startups worth more than $1 billion. A dynamic startup ecosystem has spurred a culture of entrepreneurship among young Chinese, which is enthusiastically supported by the government, and thus likely to foster a new wave of champions. Moreover, the pandemic has accelerated the use of technology among Chinese consumers and companies. This trend, and the fact that sectors such as fintech remain relatively underdeveloped, bodes well for the future growth of VC in China.
3. Corporates and the government strongly support PE activities
China’s business community and government recognize the value of PE as a reliable and necessary source of capital for the private sector. Unlike in mature economies replete with deep debt- and equity-funding options, China’s economy has a paucity of sources from which private sector businesses and their shareholders can obtain funding. This provides a gap in the market for PE. For example, state-owned enterprises (SOEs) tend to attract the majority of bank lending, in part because they are deemed more credit-worthy than their private sector counterparts. This chokes off access to financing for private firms. Even initial public offerings (IPOs) have historically skewed in favor of SOEs, to the detriment of private companies seeking capital, resulting in domestic bourses that are dominated by state firms.
PE also maintains a more positive image in China than in many other countries, where industry development is often held back by negative public perceptions. This positivity is borne out by data showing that PE-backed companies in China generally post higher profits and yield higher tax payments than their publicly listed peers, and that the vast majority of executives value the role of PE partners in improving corporate governance, accounting transparency, and tax compliance. This has helped foster a regulatory environment in which the industry can thrive, exemplified by the ongoing expansion of the Qualified Foreign Limited Partnership program, under which foreign institutional and individual investors can invest in Chinese assets through PE fund managers.
4. Technical impediments to PE development are gradually disappearing
China’s domestic legal framework is becoming more robust and is already one of the top 20 in the world for contract enforcement, according to the World Bank. At the same time, PE investors are increasingly aware of the steps necessary to ensure their contracts are enforced. These trends will help support PE industry growth. Domestic capital markets are also evolving rapidly, providing a broader spectrum of possible exit paths for PE deals. For example, between 2016-18, the China Securities Regulatory Commission reduced the average IPO approval period from more than three years to just nine months. In a similar vein, the pilot launch of the Science and Technology Innovation Board in 2019 offered more flexible listing options for both onshore and offshore Chinese companies. Finally, due diligence is becoming easier due to the proliferation of experienced professional services firms, government efforts to promote corporate transparency, and the adoption of “big data” analysis that markedly reduces the time necessary to research potential industries and investments.
I have chosen 2045 as the date China will likely become the world’s largest PE market based on consensus forecasts for future macroeconomic growth rates, and by making some reasonable assumptions regarding the future penetration of PE investment in China. Of course, I could be wrong about the date, but the trajectory of the market is clear, and savvy investors should make sure they are fully prepared to take advantage.
7. Wind market data indicates that as of December 2019, SOEs accounted for 61.7% of the market capitalization across the CSI300 and Hand Seng Index, versus just 38.3% for private firms.