Betting on Change in China

China is at a turning point as policy makers try to insulate it from global recession. The outcome of this initiative will be important for private equity returns in that country.

China managed to avoid the worst of the Asian crisis in the nineties. Side stepping the Western-made financial tsunami could prove more challenging. In the last decade China has become much more deeply imbedded in the world economy effectively becoming the global workshop.

Yet China is far from defenseless. It enjoys huge foreign exchange reserves, a massive savings pool and a budget surplus of 2% of GDP – all at the disposal of a responsive government.

Monetary and fiscal stimuli packages are being launched with gusto to steer growth towards domestic consumption. And as one private equity investor noted: “China is not hindered by democracy. It can just do what ever is necessary to keep things moving and do so quickly.” And private equity appears well positioned to scoop the benefits if it delivers.

Last year there were 177 private equity deals in China worth a total US$12.8bn. Some 88 were in traditional manufacturing, 38 in services and the balance in sectors such as IT and technology. According to various surveys, the recent batch of investments have favoured retail, consumer goods, education, domestic tourism and transport. Apparently, most of these investments have been made with the domestic economy in mind, rather than the export sector – much of which is now suffering solvency problems.

There are still many billions of dollars dating from fund raisings from this year and last, which are yet to be fully invested. They’re apparently targeting similar sectors, but there is now an added enthusiasm for renewable energy (China is a leading maker of solar panels) and healthcare. The latter is set to grow strongly as a richer and soon to be ageing population seeks higher quality private medical care.

In the meantime, private equity investors complain of overly high valuations of privately-held companies. By next year valuations could ease, allowing private equity investors to position themselves ahead of the possible resumption of double digit economic growth. Nonetheless, private equity investment will probably slow, despite enthusiasm, simply because depressed stock markets make it harder to exit investments to recycle capital.

Many private equity firms have been registering IRRs of 60-70% in China. That may temporarily drop. However, if the shift to towards domestic consumption works, outsized returns could be enjoyed in later years from investments to be made in the near future. And besides private equity investors should be betting on the same side as the state. In a command economy that’s probably not a bad thing.

This post originally appeared at Thomson Merger News