China’s PE boom: New capital controls open the floodgates for foreign investment

24 August 2017   Category: News, Asia, China, Global, United Kingdom   By Ian Kelly*

Given the steady opening of the market to foreign funds, activity in the RMB fund market has grown significantly over the last three years. However this growth has accelerated significantly since China introduced capital controls to stem outward flows and further promote international usage of the RMB.

The scale of this boom is quite remarkable; according to Prequin data, 17 new funds were launched in 2016, raising a total of US$77.8 billion. This was already a near-doubling of activity from 2015, however so far in 2017 a total of 36 new funds have been launched raising $672.33 billion – representing a 764% growth in capital raised from the previous year. The RMB funds market has clearly kicked into a higher gear.

There are a number of factors converging to drive this boom, both on the markets and the regulatory/structure side. Firstly, the steady opening up of the domestic funds market to international players is obviously playing a key role. It is much easier now for foreign firms to enter into the domestic market than it was just a few years ago, and they are far less limited in their activity than they were previously. The story of China’s staggering economic potential is hardly a new one, and it was inevitable that as the market liberalised in this regard that we would eventually see a substantial influx of foreign funds looking to take advantage of this untapped well of opportunity.

On the other side of the equation are China’s recently introduced new capital controls, designed to limit outward direct investment and encourage usage of the RMB both domestically and abroad (offset by further measures designed to boost foreign investment by relaxing various rules). Thanks to this there is now a large pool of money in the domestic market that simply has nowhere else to go, as well as a swathe of promising domestic businesses that are off-limits to foreign-denominated investment. As a consequence foreign firms are lining up to secure a slice of the pie (BlackRock, UBS, and Fidelity are just a few of the big names that have stated their intention to launch RMB funds in the past few months). The evidence from the data suggests that even those who historically stuck to US dollar funds are getting involved.

The maturation of the Chinese domestic market (which this process will in turn accelerate) is also playing a role. Whereas the previous market for RMB funds was largely limited to high net worth (HNW) and ultra high net worth (UHNW) individuals, China’s institutional investors – insurance companies and so on – are now growing and developing to the point where they are comfortable investing with private equity funds, opening up a whole new market segment.

There is also the fact, further down the economy, China is currently enjoying a start-up boom, with a raft of smaller businesses keen to secure investment – creating the prospect of attractive returns amid a global market still characterised by a relative paucity of investment opportunities and a surplus of dry powder.

Although the sheer scale of the recent spike in funds raised may be down to a ‘trigger effect’ from the recent reforms, there is every reason to expect that the broad pattern will continue in the direction of substantial growth. The Chinese government clearly intends to steadily open the market more and more to foreign investment over time, and we are only part way through that process. Indeed, further relaxation of restrictions – from preferential tax treatment for foreign investment enterprises (FIEs) to the forming of national-level ‘development zones’ designed to encourage foreign investment in Western and Northeastern regions – are already on the imminent horizon.

As the domestic economy continues to mature in turn, this process will create a virtuous cycle; as the market becomes more regulated and standardised, foreign players will become ever more comfortable investing in the region, and domestic institutions and companies will increasingly turn to the private equity market. Some of this will simply mandate increased activity – e.g. China’s inclusion in the MSCI index now means that a lot of passive money simply has to be invested there at any given time.

There may, of course, be bumps in the road. China’s regulatory authorities are notorious for making quick, sharp changes without the accompanying periods of consultation and preparation that investors are used to in the West, so there is there is the potential for hiccups. But the mid-to-long term trend seems clear.

As the market grows and matures we will also likely see an accompanying growth in the secondary ecosystem – e.g. the outsourced fund administration, technology, compliance and so on that is already fairly established in Western markets. Augentius’ most recent annual industry survey showed that half of all Asia-based fund managers polled are considering outsourcing their fund administration in the immediate future.

Of course, there are key considerations for managers looking to set up new RMB funds. The foremost danger to avoid is assuming that domestic Chinese investors will behave the same way, and have the same expectations, as their Western counterparts that you are more used to. Although the market is rapidly maturing and will likely, in time, ‘Westernise’, this is not quite the case yet. A successful entry into the RMB market must involve more than a ‘cookie cutter’ approach – instead managers should tailor their offering to the idiosyncrasies of the Chinese market and be willing to do things slightly differently.

* Exclusively written for AAM by Ian Kelly, CEO at UK-headquartered private equity and real estate administrator Augentius