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The future of private equity and venture capital in China is threatened by a huge overhang of illiquid investments. US institutional investors and pension funds are at risk in a market that until recently was a source of significant investment profits. Private equity secondaries offer a potential way out, according to China First Capital.

China’s private equity industry, having grown in less than a decade from nothing into a giant rivaling the private equity industry in the US, is in the early stages of a unique crisis that could undermine the remarkable gains of recent years, according to a newly-published research report by China First Capital, an international investment bank. Over $100bn in private equity and venture capital investments is now blocked inside deals with no easy exit. A significant percentage of that capital is from limited partners, family offices, university endowments in the USA.

Private equity firms in China are running out of time and options. Exit through trade sale or M&A, a common practice elsewhere, is almost nonexistent in China. One viable solution, the creation of an efficient and liquid market in private equity secondaries in China where private equity firms could sell out to one another, has yet to develop. As a result, private equity general partners, their limited partner investors and investee companies in China risk serious adverse outcomes.

Secondary deals will likely go from current low levels to gain a meaningful share of all private equity exits in China, China First Capital said.

In all, over $130bn is now invested in un-exited private equity deals in China. The un-exited private equity and venture capital deals are screened and analysed across multiple variables, including date, investment size, tier of private equity firm, industry, price-earnings ratio.

Secondary deals potentially offer some of the best risk-adjusted investment opportunities, as well as the most certain and efficient way for private equity and venture capital firms to exit investments and return money to their limited partners, the report finds. The most acute need for exit will be investments made before 2008, since private equity firms generally need to return money to their limited partners within five to seven years. But, more recent private equity and venture deals will also need to be assessed based on current market conditions.

Over the course of the last twelve months, first the US stock market, then Hong Kong’s, and finally China’s own domestic bourse all slammed the door shut on IPOs for most Chinese companies. As a result, private equity firms can’t find buyers for illiquid shares, and so can’t return money to their Limited Partners.

“Many private equity firms are adopting what looks to be an unhedged strategy across a portfolio of invested deals waiting for capital markets conditions to improve,” according to China First Capital’s chairman and founder, Peter Fuhrman. “The need for diversification is no less paramount for exits than entries,” he continues. “Many of the same private equity firms that wisely spread their LPs money across a range of industries, stages and deal sizes, have become over-reliant now on a single path to exit: an IPO in Hong Kong or China. By itself, such dependence on a single exit path is risky. In the current environment, with most IPO activity at a halt, it looks even more so. ”

Secondary activity in China will differ significantly from secondaries done in the US and Europe, he added. Buyers will cherry-pick good deals, rather than buying entire portfolios, and escape much of the due diligence risk that plagues primary private equity deals in China. Sellers, in many cases, will be able to achieve a significant rate of return in a secondary sale and so return strong profits to their limited partners. Private equity-invested companies stand to benefit as well, since a secondary transaction can be linked to a new round of financing to provide additional growth capital to the business. In short, secondary deals in China should be three-sided transactions where all sides come out ahead.

But, significant obstacles remain. The private equity and venture capital industry in China has grown large, but has not yet fully matured. The industry is fragmented, with several hundred older dollar funds, and several thousand Renminbi firms launched more recently, some fully private and some state-owned with most falling somewhere in between.

Absent a significant and sustained surge in IPO activity in 2013, the pressure on private equity firms to exit through secondaries will intensify. According to the report, no private equity firm is now raising money for a fund dedicated to buying secondaries in China. There is a market need. As a fund strategy, private equity secondaries offer Limited Partners greater diversification across asset types and maturities in China.

Private equity has been a powerful force for good in China, the report concludes. Entrepreneurs, consumers, investors have all benefited enormously. Profit opportunities for private equity firms and Limited Partner investors remain large. Exit opportunities are the weak link. A well-functioning secondary market is an urgent and fundamental requirement for the future health and success of China’s private equity industry.

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