The Chinese state is pumping funds into private equity

S.TATE CASH burns a hole in the pocket of the secretary of the Shenzhen Communist Party. Wang Weizhong said late last year that the government would bear 40% of its losses if they set up a fund in the South China technology center. For the monstrous 400 billion yuan ($ 62 billion) sovereign wealth fund that supports such activities, a 3 million yuan investment - the size of a typical Angels' investment - is a rounding error. For private investors, the invitation sounds too good to be true. It could be.

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After several years of loose monetary conditions and record transactions, liquidity in private equity (PE) in China began to dry up in 2018. New regulations made it difficult for banks and insurance companies to invest. In contrast, the so-called "government-run" funds set up by local governments or national ministries flourished. Local authorities have been encouraged to launch such investment vehicles to attract startups to their cities along with talent, technology and, ultimately, tax revenues. Due to a lack of in-house investment talent, most of them worked as limited partners (LPs) in private-sector funds.

Since 2015, more than 1,000 government-run funds have surfaced across China. By the end of 2020, they were managing around 9.4 trillion yuan, according to China Venture, a research company. A national fund focused on modernizing manufacturing technology held 147 billion yuan at the last count. One who specializes in microchips topped the 200 billion yuan mark in 2019. Almost every major city across China has its own fund. A municipal fund in Shenzhen claims that it has assets under management of more than 400 billion yuan, making it the largest urban manager of its kind. In the northern city of Tianjin, the Haihe River Industry Fund provides 100 billion yuan along with another 400 billion yuan from others Available to investors.

As a result, the PE in China is now congruent with the state funding. In 2015, private sector money made up at least 70% of the limited partnership funds that flowed into the industry. At the end of 2019, government-sponsored funds made at least as much. Their dominance has only increased since then; according to some counts, they hold more than 90% of the money in Chinese funds of funds (ie those that invest in other funds). According to the Chinese media, dealing with government funds is now a “compulsory course” for sports facility managers.

Some state influence is now inevitable. But whether this is an advantage or not is hotly debated. Some investors and advisors say that raising government funds can help balance private and public interests. "Government LPs can open doors for you," says Kiki Yang of Bain, a consulting firm. Government fund managers often understand local policy goals and can steer investors in the right direction, says a venture capital investor. Influence can go too far, however: Shenzhen Capital, a giant sovereign wealth fund, posted pictures on its website of a meeting held in December where it helped each of the 42 companies it invested in, a Communist Party committee to found. These are seen as a way to infuse private companies with party ideology.

There are other disadvantages as well. State funds are “crowding out other LPs,” says one of China's leading venture capital investors. There have also been significant conflicts of interest. Members of the Chinese PE elite have bitten their teeth at global investment groups such as KKR and TPG, two American companies. Their main goal is to get high returns on LPs. Not so with state-controlled funds. “There is seldom a managed fund that chases returns,” says an advisor to several of them. Instead, government investors primarily seek to generate a profit on local tax revenues by attracting new businesses, especially tech companies. Balancing these interests can create tension, says a China-based investor, and often leads to investments that depend on whether or not a company is willing to move to a particular city. Some even fear that such problems could gradually lower total returns for private investors.

So far, however, the scheme has worked well for many private funds. Since smaller funds have died out in recent years - be it due to a lack of capital or enormous losses - the competition for target assets has eased somewhat. The market is healthier, say investors, as private and government capital is directed to better fund managers.

But will it take? One of the persistent concerns of some PE investors is that government funds could dispense with middlemen and make more direct investments of their own. Several large government funds have recruited private banks and law firms to strengthen their ability to do business, notes an attorney who works with them. “You are starting to compete with us directly,” says the venture capital investor. Private investors will appreciate government money much less if they struggle to outbid it. ■

This article appeared in the Finance & Economics section of the print edition under the heading "Serving a Greater Purpose"

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