Private Equity in China: Heating up, but ‘Veiled in Uncertainty’

The outlook in China for private equity (PE) investors to earn acceptable returns remains uncertain following the recent reopening of the initial public offering (IPO) market after a 15-month freeze. Wharton experts predict tough days ahead for PE investors in the country as price wars for attractive investment opportunities threaten to erode the outsized returns PE firms typically seek.

Shanghai Stock ExchangeInitial reports, nevertheless, look favorable. The 48 IPOs listed on the Shanghai and Shenzhen exchanges in the first quarter posted record returns, averaging 54% above listing price compared to 9% for the rest of the world, according to a recent Bloomberg report.

But that IPO cheer looks likely to be short-lived as other concerns mount about private equity in China. On May 20, China’s securities regulator said it would limit IPOs to 100 through the end of this year. Even before that announcement, other, market-related limits had the potential to discourage activity. For one, too much money is chasing too few deals, observers say. Many PE investors, including the government, are flush with funds. Second, a paucity of worthy investment opportunities is lifting valuations and narrowing the hoped-for level of returns. Third, the IPO market has not yet become a dependable exit. Fourth, warranted or not, fears abound over a rash of corporate debt defaults. And overhanging it all remains economic and political uncertainty.

 “The uncertainty in China is as high as I have ever seen it on both economic and political fronts,” says Wharton management professor Marshall Meyer, who routinely consults with Chinese companies on management strategies. He lists the negatives: declining export growth; excess industrial capacity where steel mills are being dynamited to turn them into farmlands; a declining middle-income market; and concerns over financing care for the elderly, among other factors. Consequently, huge capital outflows from China are headed for the U.S., he says. “Why are the Manhattan real estate market and the New York Stock Exchange so robust? Money from China is flowing into the U.S.”

This story was first published by Knowledge@Wharton, May 30, 2014.

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