China's venture capital (VC) and private equity (PE) firms have seen a sharp drop in activity this year, following a period of rapid expansion. An industry reshuffle is now expected, with many firms expected to shut down or seek opportunities in other sectors.
In the first three quarters of 2012, domestic PE firms raised a total of $7.9 billion for investment, much less than the $35.7 billion raised in the same period of last year, and the $25.6 billion in the first nine months of 2010, according to a study e-mailed to the Global Times by consultancy firm Zero2ipo.
Domestic VC funds raised a total of $6.04 billion in the first three quarters of 2012, less than the $21.3 billion and $9.2 billion raised in the same period of 2011 and 2010, respectively, according to the study.
A number of small-sized PE and VC firms, which were set up only two to three years ago, have already closed or turned to other business areas, Li Weidong, research director at financial consultancy China Venture, told the Global Times.
"An industry reshuffle, which will involve consolidation and a dramatic decline in the number of small- and middle-sized PE firms, is coming," Li said.
Boom is over
China's first VC fund was initiated by several ministries including the Ministry of Finance in 1984, when the country had few competent fund managers. The sector experienced slow growth until 2004, when US-based Newbridge Capital launched the first PE fund investment in China by putting 1.25 billion yuan ($200 million) into Shenzhen Development Bank.
The real surge in activity for PE and VC funds began in 2009, amid the sudden increase in liquidity brought by China's launch of a 4 trillion yuan fiscal and monetary stimulus program to battle the global financial crisis.
"The prosperity was irrational in the past three years," Huang Song, director of the Financial and Industrial Development Research Center at Peking University, told the Global Times. During this time, the number of PE and VC funds in China tripled, and the growing number of investors found themselves battling over a limited number of suitable projects.
By the third quarter of 2012, however, the number of newly-launched PE firms in China had declined to 116 from 200 in the same period of 2011, according to Zero2ipo.
One of the factors that fueled the boom in the sector was the launch of China's much-anticipated Growth Enterprise Board (GEB), a NASDAQ-style secondary board, in May 2009. This new outlet for investment appeared to offer big opportunities for the PE and VC funds.
However, the GEB's performance has failed to meet expectations, partly due to the general malaise afflicting China's stock markets amid the economic slowdown.
"It is more difficult right now for PE firms to cash in by selling their shares in GEB-listed companies," Li said.
Investors have become more cautious than two years ago "because of tightened liquidity, difficulties in financing and fewer qualified projects amid the current macro-economic conditions," Zheng Zhixing, an analyst at Zero2ipo, told the Global Times.
Zheng said the PE firms will be forced to make more rational judgments in future, with more consideration for risk than before.
Try to diversify
The most common method for China's PE and VC firms to cash in on their investment is by selling shares in companies after their initial public offering (IPO). But Zheng says this is now holding back the sector.
"They need to diversify ways of cashing in, and buying shares in firms involved in mergers and acquisitions (M&A) could offer an opportunity," Zheng noted
Last year, 111 among 123 PE firms in China sold shares in companies that had just floated, while only six of them cashed in through selling shares in enterprises that had been acquired by other companies, Xie Wenli, deputy manager of the investment banking department at China Merchants Securities Co, was quoted as saying by China Economic Herald.
The situation is similar to the US in the 1980s, when nearly 90 percent of PE funds relied on selling shares in enterprises after they went public, according to the US National Venture Capital Association.
In September this year, Suning Appliance Co announced it would spend $66 billion to purchase redbaby.com, a maternal and children's products e-commerce company, which had earlier received capital investment from PE and VC funds including Northern Light Venture Capital, New Enterprise Associates and KPCB China. These firms were all able to cash in by selling their stakes to Suning.
"Setting up a special fund to help companies engage in M&As is also a feasible method, as some small-sized enterprises have encountered operating difficulties and industry consolidation is a likely trend," said Huang Song of Peking University.
Huang also encouraged PE firms to seek profits from M&As overseas, especially in developed countries with advanced industrial technologies.
Management talent needed
A lack of professional PE managers is one obstacle to the sector's development, Huang noted.
In mature developed markets, it takes about seven years to cultivate a managing director of such a firm, and even longer for a partner. But in China, many PE managers just hope to make a huge fortune overnight when the sector is booming and then turn to other industries when the market slows down, said Huang.
Salaries in the sector have also been driven to a record high level because of the limited number of experienced managers. "The basic salary plus bonuses for a senior PE manager in the insurance sector could reach as high as 10 million yuan ($1.6 million) a year," a source was quoted as saying by Securities Daily last August.
As a professor of finance, Huang said that few of his students would be competent enough to be PE fund managers after they graduate from university, due to their lack of working experience.
"It is possible that more professional people from various other industries rather than only from financial areas will step into the PE sector in the future. That would be good for PE firms' management, since these people would be more familiar with the industrial sectors they invest in," Huang noted.