China private equity still an attractive long-term strategy
Findings suggest a significantly better risk-adjusted return for China than rest of region
Against the backdrop of the recent extreme volatility in China’s public equity markets, as well as its currency devaluation and a number of downward GDP revisions, it’s no wonder that investors’ confidence is shaken, with some wondering if it’s time to hang up and exit the market.
On the ground in China, many have formed the view that Chinese private equity returns have been lower and riskier than returns in their developed market counterparts.
Indeed, when comparing the quarterly and annual performance of global private equity with returns from Chinese private equity, the latter has been significantly more volatile over the same period. During the 18 months before the first quarter of 2015, this volatility translated into higher returns relative to the global industry while Chinese private equity underperformed during most of 2012 and early 2013.
Yet when these volatile short-term returns are assessed across the life of a fund, we see a smoothing effect to performance and a sharp reduction in volatility, challenging conventional wisdom and debunking the myth that China may be losing its attractiveness as a top private equity destination.
These findings were unveiled in the latest Private Equity Navigator – a biannual analysis of the global private equity industry produced by INSEAD in partnership with eFront’s Pevara – where we find that Chinese private equity funds have performed well relative to their global peers for fund vintages from 2005 to 2012. In fact, examining returns for this period, Chinese funds in the study have outperformed, generating a pooled mean internal rate of return (IRR) of 12.5 per cent, compared to 9.9 per cent for the industry globally. Funds of the same vintages investing in North America, Europe and Asia have generated pooled mean IRRs of 9.98 per cent, 10.2 per cent and 8.3 per cent, respectively.
Further, the range of returns between the best- and the worst-performing funds in our sample by region – representing a simple measure of volatility – is the narrowest for China. The country has a high of 28.2 per cent and a low of -2.56 per cent, while Europe has the largest range including the best-performing top quartile at 30 per cent, as well as the worst performing funds at -14.4 per cent.
This is especially instructive given the perception among global investors in private equity that China is an unstable and risky market for the asset class. Although at a regional level this sentiment holds partially true, as private equity funds across Asia (including China data) of the same vintages have produced an 8.3 per cent pooled mean IRR with high volatility – our findings suggest a significantly better risk-adjusted return for China.
There are a few contributing factors to the results, and the macroeconomic argument being the most common. Chinese gross domestic product has grown at an annual rate of between 8 per cent and 10 per cent over much of the past decade, and this has allowed private equity funds to back successful entrepreneurs and invest in winning companies expanding at a multiple of the average market rate. The size of the economy versus its maturity has also regularly created pockets for arbitrage, be it the early identification of new trends and concepts, roll-ups and fast expansion strategies, non-intermediated deal flow, or multiple arbitrage in pre-IPO investments.
In fact, one can often hear that private equity is a superior way to invest into emerging economies versus public equity markets, and that can be supported by comparing Chinese private equity returns with returns on public equity as measured by the MSCI China Index. Over the eight years to the end of last year, the MSCI China Index has provided returns of 5.9 per cent compared to an 11.4 per cent MIRR (modified IRR) for Chinese private equity.
Putting in another perspective, while Chinese private equity returns show signs of short-term instability, that pales in comparison to the public market’s substantial volatility. Massive public equity swings produced highly variable annual returns of 66.24 per cent in 2007, -50.83 per cent in 2008, and 62.63 per cent in 2009. Over the same period, Chinese private equity returns were significantly less volatile, with MIRRs of 12.91 per cent, -11.25 per cent and 24.40 per cent, respectively in those three years. Note, however, that this is partly due to private equity firms’ infrequent, conservative and delayed valuations, while public markets reflect real-time returns.
There is another observation that might chime with the aforementioned negative perceptions held by some investors. Compared to Western markets, Chinese private equity returns include a significantly higher portion of unrealised returns.
While exits in Europe and in particular North America have approached record levels in recent years, thanks to favourable market conditions, the same pace of realisations has not materialised in China. For example, pooled multiple returns for North American private equity funds for the 2005-2012 vintages are 1.41x total value to paid-in (TVPI) versus 1.57x for China. However, North American funds were able to realise 50 per cent of that value, distributing 0.76x of invested capital, while Chinese funds have returned only 0.46x or just 30 per cent of the overall reported returns.
Assuming that the unrealised returns do have a basis in reality – marked to market on the basis of either partial exits, follow-on investment rounds (venture in particular) or performance of listed comparable companies – the recent headwinds in China’s public markets suggest that these unrealised returns are at risk of being corrected downwards.
At the end of the day, limited partners (investors) rate general partners (managers) based on cash-on-cash returns, meaning the jury is still out on China’s recent fund performance. However, the data does indicate that for the moment, long-term investors in a portfolio of quality institutional private equity funds in China should feel vindicated in their strategy.
Professor Claudia Zeisberger is senior affiliate professor of decision sciences and entrepreneurship and family enterprise at INSEAD and academic director of the Global Private Equity Initiative (GPEI)