China is reinventing the equity markets – and Britain’s aspirations are shrinking

First, the exposition:

  1. Exuberance for equity as a class of investment reflects how confident a given society is in their future; preference for fixed income indicates the opposite
  2. China has been reinventing the equity markets for some time now, becoming the first country since the rise of the US to really have the risk appetite for it
  3. In doing so it is breaking the convention of maturing countries in the region (Japan, Korea, Taiwan) as well as ageing civilisations such as Europe
  4. As with so much else, China is the new America

The above can be seen in a number of ways. Consider this: despite the scare stories about rising Chinese debt, it is in fact equity (both institutional and private capital) which has mostly funded fixed asset investment in recent years – averaging 66% over the last decade versus just 52% over the decade before. Anecdotally too, we know that all around us in China new startups have no problems accessing micro-equity from friends and family for the most spurious of businesses.

Self-raised funding as a % of fixed asset investment in China, 1995 – 2016

Self-raised funds.png

Source: National Bureau of Statistics

Note: the NBS splits out five categories of funding for FAI, namely Government Budgetary Funds, Domestic Loans, Foreign Investment, Self-Raising Funds and Other Funds. It is reasonable to assume that Self-Raising Funds constitutes equity investment, and that a portion of Foreign Investment may also do.

Likewise, institutional equity and equity linked investments account for a higher proportion of Chinese asset allocation than their East Asian peers – and are more reminiscent of the US in approaching 60% of allocations. Conservative Japan and Korea are the reverse. Small wonder then, that annual stock turnover in China is far higher than other markets (around 5.0x compared to c. 1.5x in the US, Korea and Japan) given the limited supply of listed equity.

Equity proportion of total non-cash household financial assets, 2016

China vs peers portfolio allocation.png

Source: Goldman Sachs Investment Research, 2016

Again, this reflects the fundamentals of not only an economy, but the society on which it sits. Buoyant equity markets reflect confidence not just in business, but in the system and the role of a country in the world. This is especially true when we think about equity provided by the retail markets, either through stock markets, or its proxies, or through earlier stage funding such as seed and venture funding where China is now the world’s second largest market. The basic principle is that when tomorrow seems like it will be better than today, people will gamble.

China still has a long way to go, of course. Its stock market capitalization per capita at c. US$6,000, still lags its peers and is just one thirteenth that of the US (and no, PPP is not appropriate here). Its private equity market, though already Asia’s largest, still has some way to catch up also at only one-third of North America. Nonetheless, China seems to be well placed to pick up the baton from the US of driving the whole culture of equity and all its attendant benefits.

And it matters. The point about equity is not just that it is one source of funding, but rather that it is a source of long-term funding and seeding for growth. A country that begins preferring fixed income to equity is giving up on its future, but also giving up on the idea of being a leader in innovation and technology. It is no coincidence that America has been the world’s great equity proponent for the last century and the cradle of  most technology; or that China is following in its footsteps. These are the hallmarks of “big countries” that make their own rules and are a force in the world.

On the other hand, a country like the UK should be very worried indeed: equity in portfolio allocations has declined alarmingly from well before the 2008 crisis. This reflects some ageing – but the ageing profile is less severe than many of its neighbours. Rather, I believe it reflects a psychological retreat from aspiration.

Changes in broad strategic asset allocation for UK plans, 2003 – 2017

UK asset allocations

Source: Mercer European Asset Allocation Survey 2017

This, much more than Brexit or the reduction of blue water navy capacity, indicates the decline of British aspirations. On a recent podcast, someone asked “but how close is China to really producing an Apple?”; the curt reply came, “how close is Britain?”, alluding to the even greater absurdity of such a prospect. If this continues, Britain will certainly no longer be a “big country”.

Private equity with Chinese characteristics

Elsewhere, I intend to reflect on my pet theme that China is reinventing – and indeed single-handedly resurrecting – equity as an asset class. In my opinion, this reflects an underlying self-confidence and correlates with the emergence of other equity cultures such as the Netherlands in the 18th century, England / Britain in the 19th and America in the 20th century, in contrast to the contemporary Japans, Koreas and Taiwans of this world.

In the meantime, developments in Chinese private equity are also worth noting. For a start, when we talk about private equity in Asia ex-Japan, we are effectively talking about just one country: the PE market in Greater China reached US$222bn in 2016, whereas SE Asia combined only managed US$37bn. The ASEAN region has not yet emerged as a market of material scale.

However the prevailing orthodoxies of PE in China are also showing that the market will not come to simply resemble OECD behavior. As many observers will know, Chinese funds operate in a grey area between classic private equity and venture capital, and sometimes throw in an element of special situations or even hedge funds to boot. This comes through in the types of deals that are done – whereas conventional buyouts still account for almost 80% of the N American market, in China this is just 20%. Instead, growth capital and PIPEs account for a much larger chunk, itself revealing that PE funds typically take smaller stakes in Chinese targets and rarely buy the whole company.

Asian private equity deals by type (2012 – 2016)

PE by type

Source: AVCJ and Prequin via Bain Asia Pacific Private Equity Report 2017

Why is this? There are a number of reasons which play a part:

  1. Stage of development – the simple point that in a high growth market, sellers may be younger and in any case desire to have a greater piece of the future upside that a company might yet deliver. It also means that there is less appetite for use of debt in the transaction.
  2. Exit liquidity – by far the biggest problem PE funds have had in emerging markets is a clear pathway to exit. Recent turmoil in the Chinese stock markets for instance cause a lower risk appetite for funds, who may find it easier to sell a stake than to shepherd the company to IPO.
  3. Control issues – perhaps the most important matter, PE funds do not always have the confidence to take a company over completely since they will be susceptible to the vagaries of China country risk. A partner of some sort often seems necessary to keep a company functioning the way it has been historically.
  4. LP involvement – this leads neatly to the preponderance of strategic investors who exist in the market, and who it is better to work with than against. LP involvement in deals stands at 29% in APAC and an enormous 57% of deals over US$1bn, compared to a global average of just 17%.

LP involvement in transactions

LP involvement

Source: Bain Asia Pacific Private Equity Report 2017

So where does all this leave us? In my mind, there are a range of different players in the Chinese PE market, and they fulfill a range of roles. On the one hand, there are the classic international players, but often these are not capable of realistically doing a deal on their own without some sort of local partner angle. On the other end of the scale, you have the very Chinese funds who retain many of the classic characteristics of Chinese business ambiguity in their dealings – at times almost seemingly linked to the state. In between you have the good stuff – the international firms who have really localized and look and smell like Chinese funds; and the few local funds who have really made an effort to westernize in their business practices, if not their focus.

Here, purely subjectively based on my own experience, is an overview of the landscape of funds in and around China:

Chinese PE.png

This will cause many an argument, I am sure. But I have tried think about ways of reflecting the degree of “localisation” too. The best I could come up with involving an excel spreadsheet was to analyse where these funds were keeping their staff – the more onshore, the more localised they might be supposed. The results were interesting if not conclusive:

PE by office.png

Source: company websites

Warburg Pincus and Blackstone represent good counterpoints. Warburg is by common consensus one of the most successful foreign funds in China, and its staffing reflects this since more than half of the Asia employees are based in Beijing and Shanghai. This reflects the 26 Greater China deals they have done against the 4 in ASEAN. Blackstone on the other hand, prefer to hub-and-spoke out of Hong Kong (a business model which has had its day, as I have written before). Their deal count is correspondingly lower. It need not be added that sheer numbers of staff can help, but only if they are the right staff in the right places.

The lesson of all this is simple: China will be a very large, profitable private equity market, but it will do so on its own terms. As with much else, assuming that China will develop along the lines of its OECD counterparts is a recipe for disaster. Whilst it has some of the framework for creating a functioning market, the behavior will be totally different. Foreign participants will have a role, but they will have to adapt. This will be, as Deng Xiaoping said, private equity “with Chinese characteristics”; but perhaps we can also add, it does not matter if it is a local cat or a foreign cat, as long as it catches deals?