Should Investors Allocate to Public or Private Chinese Investments?
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
Both! Public and private equity investments in China can be additive to portfolios today. Public equities provide investors with a diversified and broad opportunity set of companies at attractive valuations and the potential to add value through active management in an inefficient market. By participating in private markets, investors can concentrate investments in some of the highest growth, “new economy” areas (healthcare, technology, and consumer sectors), putting money to work with skilled and experienced managers. Such managers also provide diversification to global private equity and venture capital portfolios, which tend to be US-centric.
Chinese private equity (PE) and venture capital (VC) funds have created significant value for investors, with total value–to–paid-in multiples of 2.0x for vintage years 2004–15. These multiples compare favorably to those of US (1.7x) and European (1.5x) funds over the same period. Investors might argue that China’s private investments have achieved higher returns because they take greater risks, but this does not seem to be the case. Indeed, across all PE/VC investments made between 2004 and 2015 that are tracked in our database, Chinese investments have had a comparable likelihood of losing value versus US and European peers, and with lower leverage. Chinese PE/VC funds have also added significant value relative to Chinese and global public market equivalents over the past five-, ten-, and 15-year periods.
Valuations have been a driving factor behind the degree of public market underperformance, especially for Chinese public equities. Although the history is short, periods when starting valuations were particularly high, such as 2000 and 2007–08, have been associated with poor subsequent three-year and five-year returns. Current valuations speak well for prospective returns, although the strong market recovery since the start of this year has moved the public equity market from fire-sale prices to good value.
Starting valuations have a less direct impact on private investments, because managers invest and distribute capital over many years. While high valuations raise entry prices for some funds, the exit market may be particularly robust for older funds in the portfolio. Indeed, a comparison of US public market equivalents with the long history of US PE returns reveals there have been only rare instances when privates underperform public market equivalents, especially when looking at the broad market and top-quartile managers. From 1993 to 2015, relative to the Russell 3000® public market equivalent, our US VC benchmark has underperformed only 30% of vintage years, and our growth equity and buyout benchmark, less than 5% of the time. The median fund has fared worse relative to public markets, especially in venture capital, but only marginally worse in private equity.
Investors in Chinese private equity and venture capital have benefited from a wave of innovation and development, so it is logical to ask if it is too late today to invest in these markets and gain outsized returns. Investors must reassess the environment on an ongoing basis to evaluate investment themes, the manager landscape, and the market environment as current investment themes mature and new ones develop. However, several investment themes seem far from saturation and offer the potential for continued strong returns: healthcare, mobile internet, and investments related to serving changing consumption patterns.
Public and private Chinese equities both present attractive investment opportunities today. Public equity index exposure is diversified and complements private investments. When implementing active-listed equity managers, investors should be aware that some exclude or limit exposure to the more cyclical segments of the Chinese equity market, and these sectors will outperform when economic activity surprises to the upside. Within venture capital, we favor the healthcare sector, and given generally high (although moderating) valuations, we prefer early-stage managers that offer better value at this stage of the cycle. We’d only selectively invest in mid- to late-stage managers. Given expensive PE valuations and slowing growth, we favor growth equity managers that specialize—by deal type or by sector—as the market matures and differentiation matters more to the execution of deals.
Celia Dallas, Cambridge Associates’ Chief Investment Strategist