Investing in China’s Private Equity and Hedge Funds

By Roy K. McCall

More than 4,000 new Chinese hedge and private equity funds were formed in the three months leading up to June 2015.  Just three months later, almost 1,300 funds liquidated during China’s US$5 trillion equities selloff.  Between June – August 2015, China’s US$21.5 billion in hedge funds lost 17.9 percent. Venture capital and private equity was another story: with US$315 billion invested in China over the past decade, venture capital and private equity’s longer investment horizons in non-public markets protected it from volatile valuations and redemptions.

A recent Preqin Fund Manager Survey identified Asia as the region most shaken in global investor confidence.  Nearly a fifth of global fund managers surveyed planned to decrease investment in the Asia Pacific, compared to a decrease in low single digits in North America, Europe and the rest of the world. 

Global investors who invest any amount in emerging markets still cannot ignore the world’s second largest economy, China.  All are asking how to minimize damage and maximize risk-adjusted returns in the future.

How does the Asia based funds industry hope to recover?  The 2015 H2 Preqin Fund Manager Survey identified the first key differentiator of their business as a niche strategy (an overwhelming 55 percent of first place votes), followed by increased transparency (nine percent), superior investor relations (nine percent), more skin in the game (eight percent), track record (seven percent), lower fees (four percent), greater liquidity (three percent), customized service (one percent), leaving the balance of four percent to various other drivers.  In other words, managers were most concerned about risk-adjusted capital returns (i.e. returns for given levels of risk) far and above their fees, liquidity and presentation skills.  The issue of consistent excess returns reflects the top concern of the client investors themselves.

RELATED: Audit and Financial Services from Dezan Shira & Associates 

2015 has proved a valuable lesson in not trusting face value claims of high excess returns, referred to as alpha.  The key is risk-adjusted alpha over time – how does the alpha claimed play out when unexpected volatility hits the investment. Generally, valuations are cheaper when interest rates are higher and more expensive.  With interest rates low, valuations are now relatively high.

Funds generate returns when they exit investments through IPOs or private sales.  As a rule of thumb, IPOs are generally one percent of the GDP, and M&A 10 percent.  If, for example, China’s GDP were US$10 trillion, then IPOs might be expected to amount to around US$100 billion and M&A around US$1 trillion.  Recently, China has been trending US$80 billion in IPOs and just over US$200 billion in VC/PE M&A. As the CSRC (China Securities Regulatory Commission) restricts IPOs in number and pricing, funds may have fewer exit opportunities and less money to return to investors.  Because protectionism or lower economic growth expectations depress valuations, there may be fewer M&A deals and similarly less money to return investors. 

The lowered growth predictions appear to have hurt the M&A value more than government restricted IPOs.  Therefore, the real issue for M&A going forward may be the structural transition from manufacturing led exports to domestic demand driven services.

With the added government scrutiny and restrictions on China market short sellers and hedging, an investor may gain better China exposure with more liquidity through Hong Kong or off shore.  For example, ETFs such as the NYSE-ARCA listed iShares China Large-Cap (FXI) tracks the FTSE China 50 Index.  It represents over US$5 billion in value, can be shorted and offers puts and calls extending over a year.  Alternatively, for investors with a strong point of view on market direction, they can buy the NYSE-Arca YINN or YANG, which offer 3x the returns on FXI or its inverse – gratifying opportunistic ultra bears or bulls.

What’s the upshot from all of this?  Resist temptation.  Resist temptation to chase returns in VC, PE and hedge funds just because interest rates are low, and returns look more attractive over the fence from traditional investments.  Choose one’s time and pick underserved opportunities.  After all, it’s a buyer’s market, even in China.

Roy K. McCall CFA/CPA was Asia regional audit manager for Salomon Brothers Asia in the 1990s when he passed the FINRA series 7, 63, 3 (Futures) & 4 (Options Principal) exams.  For the past three decades, Roy has served Asian and Middle Eastern financial services clients, in addition to his role improving operating performance for strategic investors.   Roy also authored “Investing in China’s Financial Services Industry”.

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