After reaching record highs in 2017, private equity (PE) and venture capital (VC) backed investments faced a downturn in 2018, as stricter regulations, a change in the PE/VC landscape, and a rise in the popularity of M&A exits have made investors cautious and more selective in their investments.

Sharp decline in PE/VC market

Last year, China hit a new record in terms of the value and volume of deals backed by PE and VC investors, totaling US$40 billion and accounting for half of the top ten largest deals in Asia. However, China's VC and PE market experienced a sharp decline in the first quarter of 2018 (a decline that was mirrored in the broader market - the China outbound numbers for the quarter were the lowest since 2013 as the capital controls continued to bite). Based on the data released by the China Venture Capital Institute, the market experienced a 74.85% fall in fundraising volume, and a 54.82% drop in the number of deals compared with the same period last year. Funds that completed fundraisings in the first quarter of 2018 only raised a total of US$34 billion, down 75% year-on-year. Interestingly, around 99% of funds that completed fundraisings in 2018 were RMB-denominated funds.

RMB-denominated funds have been growing dramatically since 2009. Since 2015, trillions of government-led funds have found their way into equity investments and the VC sector, driving the creation of RMB-denominated funds. Based on the data released by Zero2IPO, from January to November of 2017, a total of 3,418 funds were established, of which 3,339 were RMB-denominated funds, with RMB 1.5 trillion in funds raised, whereas there were only 79 USD-denominated funds, with funds raised of RMB 100 billion, a 15:1 ratio. It was against this backdrop that even an average RMB fund was able to easily raise a large amount within a short period of time.

The tide started to turn in 2018. So far this year, with the implementation of various regulatory policies, both banks and local government in China have been taking a much more cautious approach to investment. Given that the VC and PE industries had become over-reliant on being fed by government-led funds, now that government investment sentiment has turned against these sectors, many VC and PE funds are struggling to attract partners and raise money.

Fundraising plummets due to stricter regulations

On April 27, 2018, the People's Bank of China, the China Banking and Insurance Regulatory Commission, the China Securities Regulatory Commission, and the State Administration of Foreign Exchange issued the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions ("New Asset Management Rules", in Chinese: 关于规范金融机构资产管理业务的指导意见), in what was a clear attempt to rein in the country's US$15 trillion asset management sector. Specific rules include removing 'implicit guarantees' ("隐性担保")¹ , raising the thresholds for qualified investors, and limiting leverage. These rules appear to be the latest in a series of government efforts to clamp down on high-risk investments made by Chinese banks using the proceeds of wealth management products, which have historically accounted for a sizable portion of VC funding in China. The New Asset Management Rules are likely to impact China's PE/VC sector in the following ways:

• Reducing the number of individual limited partners

The financial asset threshold for qualified investors in trust, private equity funds, asset management plans for fund accounts and other products has typically been set at between RMB 1 to 3 million. However, under the New Asset Management Rules, the minimum threshold has been raised to RMB 5 million. This will undoubtedly reduce the pool of qualified investors, thus adversely affecting VC funds' ability to attract money from individual limited partners.

One of the prevalent issues in China's rapidly growing asset management sector has been the wide-spread adoption of “multi-tier product nesting” between different types of wealth/asset management products.

This is also known as the 'fund of funds' model, which is essentially an investment strategy of holding a portfolio of other investment funds or products, rather than investing directly in stocks, bonds or other securities. By way of example, banks in China raise funds through the issuance of wealth management products and then invest those funds in various types of asset management companies, such as trust companies, fund managers or insurance companies. This would be the first tier. These trust companies/fund companies/insurers will then use the funds to buy asset management plans of other securities brokers /insurers/fund companies, which is the second tier.

Moreover, the insurers/securities brokers who are supposed to invest in the securities market would then invest the money into publicly-offered funds, which is the third tier.

Further downstream, publicly-offered funds may then seek to invest in bank wealth management products, trust asset management plans, insurers, brokers, which would be the fourth tier. Such multi-tranche schemes can go on and on, with more layers being stacked up within the structure.

This structure may result in money not flowing into the 'real economy', but circling back to the fund managers, banks, trusts and insurers. The reason why it was hard for regulators to regulate these multiple nesting structures was that the above-mentioned entities were regulated by different regulators, and there was often an information gap between various regulators. For example, prior to the creation of the combined insurance and banking sector regulator, the China Banking and Insurance Regulatory Commission, banks were subject to the supervision of the China Banking Regulatory Commission, insurance companies were subject to supervision by the China Insurance Regulatory Commission and brokers were subject to the supervision of the China Securities Regulatory Commission.

In addition, such multi-tranche arrangements may amplify the risks for financial institutions, as some of them used the convoluted structure to disguise the fact that they were investing in high-risk projects such as PE/VC projects which they would not be permitted to invest in through other channels due to internal risk controls.

These multi-tranche arrangements made the products opaque, highly complex and increased market volatility, as, under such arrangement, financial institutions are, in effect, using the funds collected from the public to reinvest in them and finance the issuance of various wealth management products.

The New Asset Management Rules prohibit multi-tier nesting of asset management products and limit nesting levels to a single tier. This means that commonly-used strategies by issuers (such as banks) including rolling issuance (i.e., rolling forward of products with new issuance), maturity mismatches, and separate pricing when investing in PE funds through asset management products will no longer be feasible. By way of background, it generally takes more than 6 years for a PE/VC investor to exit an invested project by way of an IPO, while the term of bank financial products are usually 2-3 years. In order to fund these longer-term investments, banks have resorted to financial tools to achieve their financing goals.

For example, a bank issues a 2-year maturity Product A financial product and invests the funds raised into a 6-year PE/VC project. When it comes to the payout time for Product A, the bank will not be able to pay the promised interest on time, as the funds are locked up in the project.

But if the bank additionally issues a 3-year maturity Product B financial product before Product A expires, then the bank can use the funds raised from Product B to pay back interest to Product A investors. If the funds collected from Product B are not sufficient to pay back all Product A investors, then the bank can offer an 'A+1' financial product to Product A investors, which would allow Product A investors to invest principal plus interest earned from Product A into A+1 at a favorable price, as long as Product A investors do not withdraw principal and interest. As a result, the bank terminates the Product A contract, and enters into an A+1 contract with Product A investors; this is known as a rolling forward with new issuance (Rolling Issuance). This serves to reduce the bank's exposure in paying back Product A investors. Since the asset and credit maturities are mismatched on the bank's balance sheet, such outcome is usually called a "Maturity Mismatch". Furthermore, although financial Products A and B are backed by the same underlying asset (PE/VC project), the prices for purchasing Product A and Product B are different due to the differences in term, which is called "Separate Pricing".

The New Asset Management Rules also unify regulatory standards for asset management products, requiring that regulators apply equal market entry qualification thresholds for all asset management operations and give equal treatment to all asset management products, in a move which is expected to get rid of the motivation for multi-tier nesting “at the source”.

The size of financial institutions' wealth management product assets under management (AUM) in China is about RMB 30 trillion, making up the lion's share of the AUM in the asset management industry. The above restrictions on these wealth management products will likely lead to further shrinkage in the scale of available PE funds for investment in the near term.

Change of PE/VC market landscape

Despite the above policy change, VC deals declined only 6.6% year-on-year during the first half of 2018, and total VC investments reached US$42 billion, up from a year ago. The average deal size is also higher than a year ago. Meanwhile, there was an increase in the average value of PE-funded deals, which was US$53.78 million per deal, an increase of 148.75% year-on-year. This shows that the fundraising drought has led to more targeted and focused investment, demonstrating that investors are becoming more selective about their investments and prefer to put their capital into more 'blue chip' companies.

The somewhat cautious approach of investors towards making equity investments has also led to a change in China's current PE landscape. Unlike mature western markets, such as the U.S., which are buyout-heavy, China's PE market has historically primarily been dominated by VC and growth funds. However, such landscape is shifting slowly. Due to stricter regulations, major investors like banks and government-led funds are investing more into fewer top buyout funds rather than pouring money into multiple low-profile VC and growth funds. This new trend is exemplified by Hillhouse Capital Group's recent successful fund raising of US$10.6 billion for its third, and largest, buyout fund.

Buyout funds have long been recognized as a key operating mode for international PE funds. In terms of increasing the value of target companies, unlike VC and growth funds, which essentially rely on the abilities of the original management team of the target company, buyout funds tend to proactively participate in management and restructuring of target companies. However, mega buyout funds have, until now, rarely been seen in China due to investors spreading their risks across multiple VC funds and growth funds. As a result, buyout funds have often been priced out of mega deals by giant corporate investors, and have lacked the dry powder to make a knockout bid.