Rush for the exit

Zhihu is to China what Quora is to the US: a reliable source of answers for users’ questions – often provided by experts in their respective fields. Indeed, when Zhihu’s founder, Zhou Yuan, was recently touting his Series E funding, he told investors how an elderly neighbour from his hometown had visited him to let him know how answers on the site had helped him successfully defend a lawsuit.

The pitch appears to have worked, for Zhihu has just raised a further $270 million from Tencent and Lighthouse Capital, among others. Insiders tell 36kr.com that it is now valued at $2.4 billion, up from about $1 billion at the time of its last fundraising in January 2017.

Zhihu has seen its valuation expand almost neck-and-neck with Quora, which was last valued at $1.8 billion in April 2017. Both companies were founded around the same time (Quora 2009 and Zhihu 2010) and have a similar number of users (180 million for Zhihu and 200 million for Quora, although the former are all Chinese whereas the latter’s active customer base has expanded into eight other languages).

Both have also benefited from the global private equity boom, which resulted in a record $453 billion being raised in 2017, according to Preqin figures. But the burning question is how much longer the good times can last for these private equity players with the US raising interest rates and China on a deleveraging path?

Recent data releases suggest a growing divergence in fortunes, particularly in China where the private equity and venture capital sector is a lot less mature than in the US.

Bigger fundraising rounds for fast-growing unicorns, classified as deals over $250 million, continue to grow strongly. Zhihu is one such company, still benefiting from fierce competition among private equity and VC players for the best deals.

But as iFeng.com reports, “winter is coming” for smaller players in the private equity space.

“Many private equity and VC institutions are facing a life or death situation,” the website reckons. “They’re finding it difficult to raise money, they can’t find good investments and they’re struggling to achieve exits from the ones they’re already in.”

Wallstreetcn.com relates a similar story. “Small institutions with a poor track record are finding it hard to raise money,” it states. “The market environment is tightening thanks to strengthened financial supervision such as the new asset management rules, which make it difficult for banks to invest in non-bank products via pooling arrangements.”

Recent figures reported by the Asset Management Association of China show that 114 private equity companies failed to reregister during the first half of 2018. And Matrix Partners’ Zhang Ying tells Wallstreetcn.com that up to 80% of China’s private equity funds will face challenges over the next five years.

Qian Mingfei, chairman of local private equity firm Yingke, adds that investment capital will increasingly flow to larger players in China, as it did previously in the US.

Figures for the amounts raised by private equity funds vary according to the different global data providers. One of the most widely cited is Preqin, which says the global total was down 7% year-on-year between April and June, in the worst second quarter for the industry since 2012.

In 2017, Preqin calculated that American private equity funds raised $186 billion. Europe came in second on $72.2 billion and China third on $64 billion.

ChinaVenture says a total of 426 Chinese private equity and VC funds raised new money during the first half of 2018, down 19.51% on the same period during 2017. The amount they raised dropped further still. According to the data aggregator, it was $34 billion between January and June, some 75% less than the same period in 2017.

“The fundraising drought has led to more cautious investment activity,” it reports. “General partners are turning to investments in top-tier companies and helping portfolio companies to add value.”

This trend demonstrates something of a shift for China’s private equity industry. Traditionally, funds have purchased minority stakes in unlisted growth companies rather than try to maximise value from buyouts in longer-established ones.

In the US, funds typically generate 50% of their eventual gains from buyout strategies. In China, it is still only about 10% to 20%.

This is partly because many companies in China either have founders that want to retain control or are state-backed. Where buying a controlling stake is possible, the private equity funds often find it hard to recruit the right talent to operate such portfolio companies (although this is gradually changing).

Another major difference between the US and China lies with ownership of the funds themselves. In the US, the biggest owners are likely to be a private sector entity. For example, in 2017 Apollo Global Management raised a record-breaking $24.6 billion for its Apollo Investment Fund IX LP. Likewise, the world’s biggest private equity fund is Softbank’s $100 billion Vision Fund.

In China, the biggest funds are almost all government-owned. The largest is the China Structural Reform Fund, which has Rmb350 billion ($51 billion) at its disposal, followed by the China Integrated Circuit Investment Fund (Rmb200 billion) and the China State-Owned Capital Investment Fund (Rmb200 billion). The leading private sector players are much smaller. Hony Capital, for instance, has about $10 billion under management (it is backed by Legend). Hopu – a private equity firm founded in 2008 by investment banking rainmaker Fang Fenglei – has raised three funds totalling around $5.6 billion. Neil Shen’s Sequoia Capital China – which has assembled one of the most envied portfolios of tech companies – added $6 billion of new money in June, having earlier raised about $2.5 billion.

A quick glance at the biggest recipients of private equity investments shows that the fundraising downturn has yet to impact on the hottest targets. Crunchbase figures show that Chinese companies accounted for six out of the world’s top 10 fundraisings in July. They were led by JD Finance, which garnered investments worth Rmb13 billion ($1.9 billion) in Series-B capital, followed by China Media Capital on Rmb10 billion for its Series-A funding round. The other four recipients: Suning Sports ($600 million), WeWork ($500 million), Didi Chuxing ($500 million) and Zuoyebang ($350 million).

However, it may not be long before investee companies are hit by the dampening effect of the burgeoning trade war between the US and China, which has already impacted exit valuations through IPOs.

Financial analysts report that Chinese internet companies are now trading around 6.23 times price-to-book, close to 2016 lows. Second quarter earnings misses have also accelerated the downturn. As we pointed out last week, O2O food delivery giant Meituan Dianping has been forced to slash its IPO valuation by 40% (to around $35 billion) due to market conditions and competitive threats. Key will be whether this is short-term turbulence or the beginning of a prolonged downturn.

China’s sliding stock markets have resulted in fewer IPOs too. According to Zero2IPO, private equity funds exited 266 investments through the stock market during the first half of 2018 compared to 572 during the same period the year before.

M&A exits, which typically command lower valuations, are on the increase though. The data provider says there were a total of 687 exits during the first half compared to 244 during the same period in 2017.

Industry experts say the private equity landscape is going through a necessary consolidation. Smaller private equity funds will be squeezed out over the short-term to the benefit of larger ones with the resources to hang around.

Fewer IPOs are taking place on China’s tech-heavy Third Board (NEEQ) as well. But the exchange’s recent agreement with the Hong Kong bourse could give private equity funds greater opportunities to realise gains in the future. Junshi Biosciences, which is owned by a number of private equity funds, including Hillhouse Capital, will be the first to test the new route in the third quarter, after filing for a $500 million secondary listing on HKEX.

Zero2IPO’s Ma Rui agrees that investment activity has dropped. But he concludes too that for “institutions that don’t lack money, the next six months to one year will be a prime time to make bargain investments”.

Of course, unmentioned so far are the ‘elephants in the room’. Though strictly-speaking not classified as private equity players, both Alibaba and Tencent have a huge presence, buying up firms to bolster their respective ecosystems and acquire new technologies. For instance Tencent has invested in 600 companies over the past six years. The dealmaking of these two tech giants looks unlikely to diminish. Indeed, some say they could prove the fallback buyer for China’s smaller, more desperate private equity players.

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