How Chinese investors and private equity firms can boost growth

09 September 2020 4 min. read

The Chinese private equity market has been charting a course to growth in recent years, and could continue to do so despite a setback from the Covid-19 crisis. This is according to a new analysis by McKinsey & Company.

Private equity and venture capital funding in China has been on the steady rise over the last decade, growing at a compound annual growth rate of 26% and 35% respectively between 2009 and 2019. Growth has been historic, and far outstripped other private investment channels such as real estate and infrastructure.

According to McKinsey & Company, private equity has been the most dominant instrument in the private funding market share, rapidly growing its occupation of the market. The numbers are highly promising, particularly as China competes in an increasingly competitive Asian private equity landscape, and looks to take centre stage at the global level.

Share of private equity funds in total fundraising

Despite the promising numbers, however, the researchers point out that there is much room for growth. When it comes to private equity as a share of the GDP, China falls well behind major global players such as the US and the UK. In these markets, private equity contributes well over 2% of the GDP, a figure that stands at 0.5% for China.

According to McKinsey, there are several factors – immediate and underlying – that have brought about this scenario. For one, Covid-19 has not done the market any favours. In fact, deal volume has had a year-on-year fall of over 70% since the start of this year. That being said, the prestigious consulting firm highlights that this is nothing more than a temporary blip on the radar.

Chinese private equity firms

At a more fundamental level, barriers to private equity growth in China are a product of imbalance. The funding market tends to be dominated by state-owned enterprises, while McKinsey reveals that the private funding market leans heavily towards a handful of major general partners. Where the top ten China-focused private equity firms accounted for less than a quarter of funds raised in 2015, this figure had spiked to 30% by last year.

Another characteristic of these firms is that few are locally operated. Indeed, the total funds raised by private equity firms has been on the up in recent years, although funds coming in from private Chinese GPs have fallen by $40 billion since 2017. The decline constitutes 65% of the total market value in 2017.

Fastest growing investment vehicles in China

According to Wouter Baan, an associate partner at McKinsey in Hong Kong, the outlook will probably get increasingly challenging for Chinese operated private equity firms – which will need to stake strategic action to remain competitive.

“Valuations of target companies are likely to remain high due to intense competition. Private equity firms operating in China must also contend with higher levels of uncertainty and risk due to ongoing trade and geopolitical tensions. To continue to grow and thrive, private equity firms operating in China, above all else, will need to acquire new capabilities and adjust their strategies to create value in their portfolio companies,” he said.

Recipes for success

In its report, McKinsey puts forward four such strategies. Number one is a focus on value creation. Whether it means specialisation, diversification or expansion, general partners in China need to lay out a clear value creation strategy to attract funding from limited partners .

Strategy number two is to drive excellence in business fundamentals such as talent, governance and organisation. While a significant market from a human capital perspective, China remains lacking in certain skill areas, and filling this gap could be a tremendous value generator.

Decline in fundraising from Chinese financiers

The third recommended strategy is to refine the deal making process in itself. Building sector-specific expertise will be key here, as will having a clear idea of asset value creation. The result of these efforts will be the capacity to deliver on more complex deals than before.

Fourth, planning is key, particularly when making an exit. In fact, McKinsey suggests that private equity firms should begin strategising their exit a year and a half before the execution at the very least. The additional time allows the room to shape a “compelling equity story,” according to the authors.

Provided that private equity firms can make progress on these four pillars, McKinsey stresses that Covid-19 could actually end up being an opportunity for the market. Many businesses will be realigning their value proposition to meet new market needs and demands, creating a landscape ripe for investment.