Q
How would you characterise the Chinese private equity market in 2018?
A
We saw a deficit for the first time. There was a slowdown in funds flowing into the private market, while outflows accelerated. If you view the market as a reservoir, the water level is declining. There will be a further impact in 2019 and 2020.
Secondly, there was a large adjustment near the end of last year and the effect has been passed on to the primary market. Some investors take a longer time to make decisions.
Previously there were projects at the venture capital stage that were asking for a price for the private equity stage. But investors are cautious about such transactions and are reluctant to do it.
The project cycle is lengthening, but the valuation system in the PE market has not changed. We expect the valuation correction to continue throughout the year, as the PE market adjustment has not yet completed.
Q
Will the trend continue in 2019?
A
It is quite possible that valuations will rationalise. In some sectors, which used to have a lot of valuation bubbles, the price will decline further.
The main problems lie in those companies with a high valuation, but which still need capital even though their business model is not yet profitable.
Such companies exist in different industries and sectors. Companies which depend on subsidies for income require continuous fundraising to survive.
Investors will have questions for these companies, and valuations will be a lot lower than before.
Q
On which industries will CEC Capital focus in 2019?
A
We will continue to focus on our strong points: healthcare, TMT [technology, media and telecoms and consumption]. We have an obvious advantage in healthcare, which has become a defensive investment sector in a volatile market. We will continue our investments here.
The second area is consumer goods where we see a lot of new opportunities. With the emergence of new consumer groups and goods, the replacement of new and old brands has brought many opportunities. Here we intend to strengthen our coverage capabilities further.
In the TMT sector, we will find new opportunities in the new generation of consumers, with new content, but overall, we see a greater focus on early-stage investment.
But there are also two relatively large adjustments, one is what is known as the industrial internet, which means opportunities for business clients. The market has heated up since last year.
Opportunities have emerged up and down the traditional production line as China wants to improve efficiency via industrial chain restructuring. This is in line with our existing projects and we have specifically restructured our company to focus more on industrial internet opportunities.
Another area is advanced manufacturing. This is a policy-driven industry and closely related to China's macroeconomy, using new technology to restructure the current manufacturing model.
Some investments may involve very high-tech research in fields such as new materials. But at the moment, most investments are in post-production manufacturing, more on applications.
For financial investors, high-tech materials are not yet commercialised and not ideal for investment.
Q
How do you view the M&A market in China?
A
It is still very much an underperforming and under-served market. A lot of capital was raised last year, but significant M&As are still relatively rare.
For M&A activities to grow, you will need a healthy secondary market, which is not readily available in China.
On top of this, so-called inverse valuations featuring trading multiples that are higher in private markets than in public ones have also made it hard for public buyers to swallow private market M&A targets.
That said, we do expect to see a lot more going forward. These buyout deals will most likely happen with companies that have a sound business model and healthy cash flows. Some of these targets will be old-school traditional players, but new economy buyout targets will also emerge.
Q
What is the outlook for the technology innovation board in Shanghai?
A
The new technology innovation board is significant in many ways. First and foremost, the registration-based (disclosure-based) system and the new listing criteria is a big leap forward of fundamental importance. We hope it will lead to overarching reforms across the entire A-share market.
Second, the pricing mechanism, which is putting more in the hands of supply and demand and other market dynamics, is also a significant improvement vis-à-vis the old 23 times PE ratio guidelines.
In the short term, though, we anticipate that the first crop of companies listed on the new board will see their prices shoot through the roof, which may not necessarily be a good thing for the long haul. If too much money chases too little supply, that could spell trouble.
While it is clear that the government wants the new board to attract and support certain industries and verticals of strategic importance to China’s future development into a global superpower, we strongly believe that making the technology innovation board inclusive and not overly emphasising sectoral characteristics would benefit China more in the long run.
Q
What do startups think of the new board?
A
Many of them are taking a wait-and-see attitude. If they are onshore entities readying for a domestic IPO, then, of course, having the technology innovation board as an additional option would be a huge plus, provided that they can qualify under the current requirements.
But if they have already been structured into offshore entities with a VIE [variable interest entity] structure, then they would probably want to stay put and see if they could get listed on the new tech board with a VIE structure.
The general rule of the thumb for our clients is that when market environments are stable with a lot of certainties, you can contemplate onshore/offshore restructuring to achieve a particular purpose.
When the market is tumultuous and visibility is low, however, it’s probably better to focus on building a stronger business first and worry about capital market options later.
Q
Are you worried about price inflation for the new board?
A
We do have concerns. If the price is higher than the true value of the company, the subsequent stock price plunge will definitely have a negative effect on the technology innovation board. The best way is to let prices fluctuate within a reasonable range.
Q
What trends are you seeing in Chinese fundraising at the moment?
A
First, allocation of capital is becoming more concentrated in the hands of a smaller number of market-leading general partners (GPs) and top players in large vertical markets. The supply of capital for mediocre GPs and average entrepreneurs is definitely shrinking.
Second, there is a lot of reflection on the overall valuation approach. It used to be the case that people would look at comparable transactions completed by what they considered as top-tier investors and take them as the default benchmarks.
Today more and more people are beginning to question the validity of those valuations in the first place - are they really supported by robust methodologies or just the results of some random happenings?
Third, we are seeing an influx of late-stage VCs and private equity players moving into earlier stages to lower their average prices down the road.
In other words, they are going into earlier rounds not because they want to become angel investors or venture capitalists, but because they want to find a company in which they can pour in millions, even billions, of dollars down the road at an earlier stage: and yes, at a much cheaper price.
Q
Will the technology innovation board in 2019 activate the RMB capital pool?
A
The launch of the new technology innovation board will certainly draw some fresh RMB capital into the market. But for most truly innovative Chinese startups, it is still the deep-pocketed US dollar investors that are doing most of the heavy lifting.
Q
Will capital raising in 2019 be dominated by USD or RMB?
A
We have been seeing a steady decline in the number of active RMB investors since 2018.
In general, US dollar investment tends to be a much more stable source of capital given the nature of US dollar limited partners (LPs).
For 2019, we believe US dollar investment in China’s primary market will remain relatively stable, with some new faces such as certain hedge funds, sovereign wealth funds and family offices unfamiliar to the Chinese market popping up here and there.
In terms of RMB supply, although there is still a lot of money in the market, it is primarily flowing into the hands of a small number of state-owned asset management platforms.
Given that much of the capital inflow is coming from various levels of government and state-owned enterprises, it is only natural that a lot of the investment activities in the RMB space will be policy driven.
Being politically correct will be essential to secure large RMB investments from state-owned investment platforms and financial institutions.
Q
Are US dollar investors still looking at China despite the economic slowdown?
A
While the economic growth in China is more sluggish, of all the major economies that exceed $1 trillion (along with India) it still offers the highest economic growth. At the end of the day, the combination of its massive scale and a growth rate of around 6% still makes it very attractive to a lot of outside capital.
Second, in anticipation of an economic slowdown in China and the worsening of other structural issues, some global funds have pulled back on their China allocation over the past couple of years. With the US stock markets continuing experiencing downward adjustment pressure, some are quitting slowly from China for a re-adjusted portfolio balance.
Finally, as China's stock markets open up and some Chinese companies are included in global indices, those like MSCI are drawing traditional global asset managers and hedge funds into the game.
In order to cover the market well, they would have to hire their China analysts and investment professionals. As they build out their China presence, they are beginning to ask themselves the question: “why not going in a little bit earlier to capture more upside?”
Q
What's your view on overseas investment by Chinese companies?
A
The wave of Chinese companies aggressively snatching up assets overseas has subsided a bit due to both Chinese domestic policies as well as concerns from the Committee on Foreign Investment in the US.
There are still sporadic asset purchases, but it is becoming more challenging in terms of securing government approvals - often from both sides, foreign direct investment permission on foreign exchanges, and deal financing in general.
In the meantime, we are seeing more and more Chinese companies beginning to do business in other parts of the world. India, Southeast Asia, and even the Middle East are all emerging as the new playground for Chinese entrepreneurs. An increasing number of them have chosen to fight the battle overseas as opposed to facing extremely fierce competition at home.
Q
What about CEC Capital's capital allocation overseas?
A
Even with the headwinds in Sino-US relations, we are continuously beefing up our presence in the US. We already have a team of about 20 professionals in two locations, Los Angeles and San Francisco.
While truly cross border deals only account for a relatively small portion of our deal pipeline, many of our large capital deals will require joint efforts on both sides.
Our US team will not only provide strategic value in deal execution but will also serve as a strong extension of our ECM capabilities in the overseas market.
Unlike some of our competitors, who put greater emphasis on IPOs and secondary market investors, we want to focus on building the most elaborate and extensive global investor networks for the private market.
On the direct investment side, we are also looking at what many call “global startups” - startup companies that have duel teams and duel home markets in China and the US.
Q
What will CEC’s overall strategy be in 2019?
A
Stay alive and healthy, groom a new generation of leaders and oil the wheels on both investment banking and asset management.
We want to make sure that we continue to lead the pack in healthcare, build market leadership and expertise around the new consumer revolution, and not miss the boat on the next big wave in TMT.
In addition to our investment banking activities, we plan to raise our second US dollar fund. This will focus on the consumer market which will encompass healthcare and entertainment sectors and will leverage the resources of our overall platform as we have done in the past with our first US dollar fund and RMB fund.
Given the overall economic environment, it’s probably not the best year to be super aggressive in all different directions, but we will be highly proactive on the things we really care
about.
