China presents huge opportunities for businesses targeting its vast, and increasingly affluent, domestic population. Here, Andrew Tually and Susan McKinstray, members of our corporate and investment funds team in Singapore, consider why and how venture capital and private equity firms are increasingly looking to take advantage.
1. How would you describe the differences between the emerged versus emerging Chinese market; as well as the characteristics, challenges and opportunities that define China’s emerged market?
Andrew Tually: The data on published deals shows PE activity in China in 2019 dropped by about a half from 2018 levels. Current activity is still a long way off its peak in 2017, although China still accounts for some 50% of PE activity in Asia.
Despite recent falls, it is still an extraordinary large/active market. What is driving the trends each way?
On the positive side, all businesses – whether they are start-ups or mid-market operators or state-owned enterprises – have large domestic audiences in an increasingly digitized economy. There are over 800 million internet users (more than US and Europe combined) which allows rapid, large-scale commercialization of digital businesses. Accordingly, a lot of the new venture capital (VC)/private equity (PE) activity is focused on early stage and growth stage investments in technology, financial services, education and healthcare sectors.
On the negative side, private debt has been cheap for a number of years now, which makes PE a less attractive (or necessary) option for some investors and investee companies. Another negative is that PE targets are becoming more expensive as entire sectors are becoming more leveraged; similarly, an abundance of foreign and local managers and domestic conglomerates with active M&A appetites means greater competition for assets. Higher deal costs makes PE less attractive for managers/investors since they need to work harder to generate returns and outperform the market (and earn their performance fees).
2. How is overseas VC/PE helping Chinese businesses to take advantage of these opportunities/tackle these challenges?
Andrew Tually: With the VC/PE industry in China still relatively nascent (by US/European standards), overseas PE/VC firms have a lot to offer Chinese businesses. Other than providing the obvious capital to fund business growth, overseas VC/PE firms bring other 'soft' assets to the table: for example, sectoral or technical know-how (although China is catching up pretty quick) and other forms of intellectual capital. There is also a significant shift towards so-called 'positive capital', in which overseas VC/PE managers take into account various environmental, social and governance factors in making investments - such measures can be a force for positive change anywhere in the world, not just China. In addition, experienced overseas investors can also help to bring more overseas options to the table when it is time to exit, meaning more opportunities to realise returns later in time (i.e. beyond those available in China/Asia).
3. Are there any factors that are making international VC/PE investment in Chinese businesses difficult? If so, what and why?
Susan McKinstray: There’s no doubt that there has been a sharp increase in VC/PE investment in Chinese businesses over the past decade, with investors riding the wave of China’s surging technology sector and high returns generated from the rapid commercialisation of digital business models. Despite recent slowdown, China remains ranked as the world's second largest recipient of foreign direct investment: according to Bain’s 2019 Global Private Equity Report in 2018, global investors injected an estimated US$81 billion into Chinese start-ups – that’s 32% of invested global venture capital as compared to 47% received by US start-ups. VC/PE investment in China accounts for an estimated two-thirds of the total investment funds received in Asia.
This influx of investors has led to over saturation at the lower end of the market, prompting a decline in the number of smaller ticket deals and a focus on larger investments. The VC/PE sector in China has also been faced with further challenges due to uncertainties caused by the US- China trade tensions, a decline in funding available, and speculated bloated asset valuations of China’s ‘new economy’. Historically there have been certain barriers to entry in China with restrictions on foreign ownership, practices which favour domestic enterprises and a lack of protection for intellectual property rights, which China has been re-addressing in an effort to open its doors to foreign investors.
4. What is the experience that VC/PE funds have had targeting Chinese businesses?
Susan McKinstray: It is the large managers which have been continuing to dominate the fund-raising environment. SoftBank Vision Fund, the c$100 billion investment fund headquartered in Jersey, which Carey Olsen assisted with the set-up of, has been an active participant in the market investing in start-ups from the fintech, transportation, real estate and e-commerce sectors, including Chinese businesses and has opened offices in Shanghai and Singapore.
In fact, Carey Olsen is one of the only offshore law-firms with a dedicated Channel Islands desk in Asia and in the past year we have seen plenty of Asian managers looking to take advantage of investment and fundraising opportunities in UK/Europe, with more interest in Guernsey and Jersey VC/PE funds. Having said that, more can be done by Guernsey and Jersey VC/PE funds in the other direction to target Chinese businesses and source opportunities in China.
5. Are there any changes on the horizon that are likely to make Chinese businesses more ready for VC/PE inflows? What is the likely impact of these changes?
Susan McKinstray: Yes, China has been taking steps to attract foreign investment and improve the regulatory environment over a number of years. Whilst trade tensions had been increasing, Chinese authorities announced, in contrast to the threatened restrictions by the US, that they are accelerating efforts to open their market to foreign investors.
As part of those efforts, a new foreign investment law was brought into force from 1 January 2020 with the aim of putting foreign investors on an equal footing with domestic investors in China and to provide foreign investors with specific protections from non-expropriation of foreign-owned assets in certain circumstances, free transfer of profit/income in renminbi or foreign currency into and out of China to the lawful protection of foreign investors' intellectual property rights in China and fair treatment when applying for licences and participating in government procurement.
China has also been opening up the investment avenues for foreign investment by narrowing its ‘negative lists’; areas that were once restricted or prohibited have been relaxed e.g. transportation, infrastructure, agriculture, mining, manufacturing, telecommunications, education, health care, culture and other fields. China encourages foreign investment in modern agriculture, advanced manufacture, high technology, energy conservation and environmental protection as well as modern services.