“The old is dying and the new cannot be born,” the Italian Marxist theorist Antonio Gramsci wrote in the early 20th century. We seem to be living in a similar interregnum today, likewise marked by “a great variety of morbid symptoms”, including, not least, the breakdown of global supply chains and the return of inflation. The only way forward is to support the development of new markets, industries and institutions. But who will finance this effort?
In good times, characterized by rapid growth and fat margins, commercial banks and private markets could help emerging and efficient firms raise enough capital to acquire and restructure their inefficient and failing counterparts and create new supply chains. But tighter financial regulation after the 2008 global financial crisis, together with a prolonged period of low interest rates, has made mainstream financial institutions more cautious. They now prefer lower risks and shorter time horizons.
As a result, debt levels are at historic highs, and market concentration has increased substantially, with a handful of listed companies enjoying huge market share, particularly in the tech sector. At the same time, with public markets tightly regulated, those in search of higher yields are turning to less liquid, more opaque and less regulated private markets. According to McKinsey’s Global Private Markets Review 2023, total private market assets under management (AUM) reached US$11.7 trillion in June 2022, having grown at an annual rate of nearly 20% since 2017.
This growth was driven by the embrace of limited partnership private equity (PE) funds, which mostly invest in companies that are not publicly listed or traded, and venture capital (VC) funds, which invest in riskier startups or young businesses with long-term potential. Long-term pension and insurance funds, as well as holders of patient private wealth, are willing to wait for bigger returns, and trust PE and VC funds – especially the larger and more experienced of them – to deliver.
But whether private markets will be able to serve the goal of deep financial restructuring remains to be seen. Though private market AUM have grown faster than total global financial assets – which increased by 7.7% in 2021 – they account for just 2.4% of the total (US$486.6 trillion). Likewise, the non-bank financial intermediation (NBFI) sector, which includes pension funds, insurers, and investment funds, grew by 8.9% in 2021 – faster than its five-year average growth of 6.6%, but still much slower than private sector AUM. Private AUM amount to only 4.9% of NBFI assets totalling US$239.3 trillion.
Furthermore, enthusiasm for PE/VC funds seems to have cooled since last summer. After peaking in 2021, PE deal volume fell by 26% to US$2.4 trillion, and deal count declined by 15%, to just under 60,000.
The Chinese PE/VC market has followed a similar trend. In 2022, Chinese PE deal volume shrank by 48.7%, to US$154.8 billion, and deal count fell 16%, to 9,695. In the first half of 2022, Chinese private market AUM increased, but the total – US$539 billion – amounted to just 0.7% of China’s total financial assets and 2.7% of its NBFI assets.
But this gap may offer a valuable opportunity for China. The Chinese PE/VC market is clearly underdeveloped. With China accounting for 18% of global GDP, there is considerable potential for Chinese PE/VC funds to expand – and to support domestic economic restructuring.
Already, Chinese PE/VC funds are handling a growing share of mergers and acquisitions (M&A) – more than 56% in 2022, compared with 49% in 2018. M&A transactions have proliferated in the wake of Covid-19 lockdowns, and the number involving VC funds increased by 61% year on year in the first half of 2022.
China’s PE/VC funds have two distinctive characteristics. First, foreign funds play a significant role in the sector, offering international expertise and market reach. The problem now is that, amid rising geopolitical tensions, foreign PE/VC investment in China has declined considerably.
In 2022, only 114 new foreign currency funds were created in China, down more than 40% from the previous year. And in the first quarter of 2023, there were only 87 instances of foreign-currency funds investing in the Chinese equity market – an 87.5% decline by number and a 57.5% decline by value from the previous year.
The second distinctive characteristic of China’s PE/VC funds is that a substantial share of their funding comes from various levels of government. As of the end of 2022, Chinese government entities had established 1,531 investment funds, worth a total of about US$380 million.
The central government accounts for a very small share of these funds: just 1.5% by number and 7.5% by value. Central government funds tend to focus on investments that advance national priorities, such as in high-end manufacturing, energy and environmental protection.
Provincial- and municipal-level investment funds, for their part, aim primarily to develop regional economies. Provincial governments accounted for 24.3% of investment funds by number, and 38.4% by value, in 2022, while municipal governments accounted for 53.4% and 42.7%, respectively.
District and county governments – which account for 20.8% of investment funds by number and 11.4% by value – support companies that can stimulate the local economy. This used to mean investing in infrastructure, especially real estate, but the priority has shifted to creating local jobs and restructuring local industries. The value of these investment funds increased by nearly 54% last year.
China must reconfigure its industries and supply chains to meet the challenges posed by rising geopolitical tensions and rapid population aging. Though foreign investment in the PE/VC sector is declining, China’s government has shown that it can support the “birth” and development of private funds, equipping them to provide market-based solutions to the economy’s woes.
Andrew Sheng is a distinguished fellow at the Asia Global Institute at the University of Hong Kong; and Xiao Geng is the chairman of the Hong Kong Institution for International Finance and a professor and director of the Institute of Policy and Practice at the Shenzhen Finance Institute at The Chinese University of Hong Kong, Shenzhen.
Copyright: Project Syndicate