The predicament of China's PE/VC managers is under-appreciated
Capital exit strategies in China differ from those in Western markets.
China has a young private equity and venture capital (PE/VC) industry. And in its barely over 20 years of existence, it has helped produce some of the most successful companies in the world's history. But as China's economy changes gears, so too must this industry. It is, after all, only a borrowed concept from the West, and has to constantly adapt to the changing realities on the ground.
In a previous post, we explained how China's VCs have systematically drifted away from their Western counterparts in terms of investment strategies. But this great divergence is never supposed to be easy. [You can read that in GRR, which by the way was recently recommended as one of the good China newsletters on Semafor.]
What is less understood are the realities on the ground. Who are China's PE/VC investors? What actual challenges and constraints are they facing in this "sinicization" of PE/VC industry? How are they adapting to Chinese characteristics? Within this context, Ginger River believes the following account gives a fascinating insider view of the industry. It was first published on Wechat at the end of 2022 by Chinaventure.com.cn, a Chinese internet platform that provides economic information.
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One month ago (On November 20, 2022), I published an article called The secrets behind DPI. The article analyzed why DPI (Distributed to Paid-In Capital) is widely used in assessing fund performance, how different people use the metric, what factors influence DPI, and how the metric reflects limited partners' (LPs) anxiety toward uncertainty in investment. I put in a lot of effort to explain the ins and outs of DPI, but the concept itself and the game behind DPI are just too complex to be covered in a single article.
Kevin, a partner at a leading investment institution, read my article. He contacted me and shared his views on the article. Kevin believed that the article was written mostly from the perspective of LPs and investor relations (IR). And he suggested that I seek opinions from investment managers, (aka general partners, GPs), which will also help enhance mutual understanding among industry insiders.
I agree with Kevin. In an increasingly divided industry, media should promote communication. We have been bombarded with articles that talk about the sharp conflicts between GPs and LPs. However, constantly restating one side of the view would only deepen the rift. The key to understanding lies in giving both sides a chance to communicate and talk about their own predicaments.
Kevin works in the healthcare business in a big fund. He has witnessed the ups and downs of the industry, and is now also in charge of the fundraising work for new funds. So he has a deep understanding of the industry. In his opinion, there is a context for all the discussions, that is, both GPs and LPs in China are not very mature. For GPs, they are fettered by many realistic constraints in many cases, which means their choices get distorted sometimes.
For example, domestic investors flocked to new energy in 2022, and they dived into semiconductors in 2021. Before that, investors rushed to the consumer market. The dismal results are evident to all. However, why did these smart people still take a leap when they knew prosperity in those industries was in a bubble? No one has discussed it so far.
Kevin shrugged and explained the logic to me, "As investors, how can we not know that the new energy sector is at a high point? The bubble is very likely to burst in 2023. But it doesn't keep us from investing in new energy this year. The truth is, we could only attract customers through chasing the investment trend. When other investors talk about their investments in new energy and the projects that will start operation, how would you raise funds, if you say, I don't invest in the sector because the risk is too high?"
Therefore, we come back to the problem I have mentioned before. Even if people know the right thing to do, realistic constraints will force them to go other directions. So it would be hard to stick to the right thing.
During the conversation, I also realized that GPs are not well understood today. Kevin is in a strange position. LPs would be dissatisfied with fund returns and fund exits. At the same time, being a GP requires Kevin to continuously invest. After all these years, he invested more than he earned. With responsibility for both fund management and supporting the family, Kevin turns out to be the one that wants an exit the most.
The following is a transcript of Kevin's views, edited by Chinaventure.com.cn:
When I read your article, every paragraph makes sense from the LP standpoint. But if you think about it from the perspective of GPs, you might find that we just did what we had to.
First, in theory, MOC (Multiple on Invested Capital), IRR (Internal Rate or Return), and DPI or TVPI (Total Value to Paid In), are the impossible triangle in investment.
For certain projects, they could perform well in all the indices. For example, a project may create a revenue that is ten times of the principal. The company may go public and its shares are sold at proper times. In this way, the MOC, IRR, and DPI would be high at the same time. But for mature funds with settled strategies, it's impossible to have high MOC, IRR, and DPI simultaneously. For instance, a fund in its early stage can generate a very high MOC and a very high IRR in the first few years, but the DPI would be low. For funds focusing on Pre-IPO investments, the DPI can reach 1 very easily, but the MOC will not be high.
Second, the capital exit strategies in China are different from those of the Western markets, and China's equity market is still developing, which means it's not mature yet. A few years ago, a leader in M&A (mergers and acquisitions) started her own business in China. She wanted to focus on M&A funds. But now she becomes an investor in the PE/VC market along with everyone else. Is she incapable? Definitely not. Is it that she didn't want to do M&A? But that's the reason that she started her own business in the first place. In the end, she gave in to the market reality. Or to put it another way, the market forced her to make some changes.
So excluding share transfer, then we are only left with IPOs. In the US, no matter the Nasdaq or the New York Stock Exchange, normally only set very limited listing requirements. Even Hong Kong stock market has higher standards for listings. In other words, a company gets listed (there) if it wants. It may have a smaller market cap, but it's still a solid capital exit strategy.
In comparison, although Hong Kong stock market has finally started to align with international standards, the situation is not satisfying due to the influence of the dim macro environment. Moreover, Chinese stock exchanges are lowering the threshold for listing, but the pace, extent, and new standards have fallen short of expectations. Companies seeking IPO used to suffer from a traffic jam in China's stock exchanges. Though a set of measures have been introduced to the STAR market in Shanghai, China's stock market still has requirements about companies' profits and the development stage when they IPO. Sometimes, there exist even more barriers in practice. Some companies cannot IPO even if they meet open standards. This is a problem unique to China.
These are the realistic constraints in China. For one thing, buy-outs and acquisitions are not available in China. For another, IPOs are under strict supervision. In fact, a lot of VC investors also want to exit, but the environment is different from the west. They can't force companies into liquidation either. Because if they do so, people will reprimand investors for being cold-blooded. They will say those investors don't care about companies at all.
Furthermore, in terms of life cycle, we invest in both RMB funds and U.S. dollar funds, so we know the differences between Chinese limited partners and their foreign counterparts. When managers tell LPs who want to invest in dollar funds that the life cycle of the project is ten years, they are fine with the arrangement. Because they understand that equity investments are a long-term business. But LPs of RMB funds expect three years of investment period and three years of harvest period, or five years of investment period plus two years of harvest period. I work in a leading institution, and we are barely able to get four years of investment period and four years of harvest period, which is another difference between China's capital market and foreign ones.
Third, though our roles are general partners, only few of us are full-time general partners living on management fees. In most cases, general partners are also limited partners. [Note: differences between general partnership and limited partnership] Take the fund I work in as an example. I am a general partner now, and partners must also invest when the fund invests. I have been working for the fund for nearly a decade. For the money I make, one third goes into my pocket, and I have to invest the rest back into the fund. This is why my family are not happy about my job. To them, it's as if I've been working for the company for free.
Therefore, GPs understand LPs. After all, GPs also invest their own money into their funds. The two percent management fees are only divided among top partners. As low as five GPs in a fund can receive the fees in some cases. The rest of the partners rely on their work performance and dividends. Under these circumstances, we certainly hope projects go well, because only in this way can us managers get our money back.
Fourth, your article mentioned that some LPs manage investments themselves. In my opinion, managing investments is not as easy as it seems. To put it in a simple way, it looks like investment is about simply putting money into a project, and everything is done. But the truth is, you have to pick projects and do background research first. After the money is in place, you may need to spend years managing the investment, including finding the right exit time, and getting the money back. Nowadays, some LPs think that GPs did a bad job and they themselves can do much better. But when LPs truly get their hands on investment, they find out that the situation is even worse. However, since they themselves are the decision makers, they have to swallow the bitter pill.
Many LPs say they prefer pre-identified funds over blind-pools. Because they want to know where their money goes. At the beginning, LPs would be like, it's okay, I root for the project, I want to invest my money, and I will take the risk with GPs. But according to my observation over the years, once the project goes south, LPs will always blame GPs for the investment decision.。
Fifth, both China's GPs and LPs don't have much experience. My fund has been in this business for over a decade, and witnessed major economic cycles of China, so we know how to live through good times and bad times. In good times, we will not invest too aggressively, and in bad times, we'll try to find some bottom fishing opportunities instead of tying our hands.
In my decades of experience in investing, I have taken part in multiple rounds of fundraising. During these years, RMB fund LPs come and goe, but U.S. dollar fund LPs basically stay the same. We even had a 100 percent reinvestment rate in a U.S. dollar fund.
Years ago, many RMB fund LPs belonged to the "three types of shareholders" (asset management plans, contractual funds and trust plans), and some were insurance companies. But when we tried to raise the next round, regulators banned "three types of shareholders" and insurance companies from investing in funds, so we turned to social capital and state-owned enterprises. Now as we launch another round of fundraising, it seems that local government-guided funds will dominate. And insurance companies are back in the game again.
Amid changes, there is always a group of high-net-worth LPs. Of course, the individuals in the group are no longer the same, so are other LPs. Therefore, both parties are underexperienced, and even professional LPs do not have much experience coping with economic cycles. Many became LPs only after China opened up the capital market, or after the capital market flourished around 2015. The same is true for GPs. In my memory, nearly 18,000 investment funds sprang up in 2018 and 2019, which means most GPs only experienced the upward cycle.
This is the current situation in China's PE/VC market: both LPs and GPs are newcomers who have only been through the good days. However, now we are in a downward period while both sides have little experience. If you accuse anyone of doing a bad job, he will feel wronged. In fact, this is inevitable after the market underwent expansion, a process that ensures the fittest players survive.
Sixth, as I said before, GPs' income is related to their work performance. In China, GPs' work performance also has something to do with the general atmosphere in the industry. For example, if the industry a GP focusing on performs well, some LPs may ask, why not invest in more projects in this industry? But this is not how things work. For one thing, domestic funds generally are divided among partners. In comparison, foreign funds have a more developed benefit sharing mechanism, which means if a GP invest in a good project, other partners can also get dividends, so no one would interfere with the project considering everyone wants to make more money. For another, each partner has limitations. For example, I only focus on the healthcare industry and I can seize opportunities in the area I'm familiar with. However, every industry has a life cycle. The healthcare industry is pivoting [downwards] this year, so I put my focus on fundraising [instead of investing]. Indeed, I still invest in some projects, but the total number is down by half compared with last year.
Moreover, I had to make investments in low profile. LPs wants our company to invest in star projects, like those in the new energy sector, especially when money from state owned enterprises accounts for more than 50 percent of the fund. Think about this, what do LPs from state owned enterprises want when they report to their leaders? Of course, they want to present investments in new energy projects. What should they do if GPs didn't invest in any of those projects?
Therefore, investing in semiconductors in 2021 and new energy in 2022 become inevitable. If a GP didn't follow the trend, LPs would question GPs' decisions. As investors, how can we not know that the new energy sector is at a high point? The bubble is very likely to burst in 2023. But it doesn't keep us from investing in new energy this year. The truth is, we could only attract customers by chasing the investment trend. When other investors talk about their investments in new energy and the projects that will start operation, how would you raise funds, if you say, I don't invest in the sector because the risk is too high?
In such context, fund performance will absolutely suffer. This also reflects a difference between China's investment ecosystem and foreign ones. In China, sometimes the focus of GPs' work is not about making wise investment, which is rarely the case for foreign GPs. For U.S. dollar fund LPs I have known over these years, they are the silent investors that don't involved in investment decisions, including reinvestments. The only requirement they have is to meet ESG (environmental, social, and corporate governance) goals. If I explain to them why we don't invest in certain areas. As long as the decision makes sense, LPs will agree with us. They understand that chasing the investment trend is not wise.
In conclusion, multiple factors contributed to the current dilemma between LPs and GPs. For GPs, they are fettered by many realistic constraints in many cases, which means their choices get distorted sometimes. But we have to make compromises to make money.
The PE/VC market is an ecosystem that relies on different participants to cooperate with one another, no matter the market works in the U.S. way or the Chinese way. In the past, I used to spend a lot of time explaining valuation adjustment mechanism to entrepreneurs, and brief U.S. investors about the situation in China. Because I believe understanding is the premise to make the right choice. If you don't want to make long-term investments, you should choose a Pre-IPO fund. But in that case, the multiple won't be high. It is unrealistic to want it all.
(Kevin is the pseudonym required by the interviewee)
Very insightful explanation of the differences inherent in the Chinese investment system!
So interesting how the culture affects the process. People often feel they are well aware of the regulatory differences that come from very different government structures. But you shed light on some of the more interpersonal cultural differences that have a major impact on investment decisions and strategy. Very very interesting!
Thank you (and thank Kevin...)