This article was written by Jerry Choi, Kendal McCarthy and Guo Sun Lee.
Analysts estimate that nearly US$1 trillion left China in 2015, and over the course of the past year, we continue to see alarming rates of capital outflow. This article examines some of the reasons why, and we offer our insights as to what GPs and LPs in Asia might expect as a result.
How does one explain China’s tremendous capital outflows? No single factor is responsible, but we might consider the following to be key:
- Stock market fluctuations: since the country’s stock market crash in Q3 of 2015, Chinese investors have hastily pulled their money out of China, as they hoped to diversify their portfolios and hedge against any depreciation of the RMB. The crash prompted many funds to be liquidated ahead of their original settlement dates.
- De-valuation of the RMB: the surprise decision to devalue the currency last year created uncertainty among investors, who moved their money with hopes of protecting returns.
- Liberalisation of regulation: the advent of Free Trade Zones (which allow foreign asset managers to sell overseas investment products directly to wealthy Chinese clients), the NDRC’s liberalisation of China’s outbound investment regime, and other changes have allowed for money to flow out of the country much more easily.
- Anti-corruption crackdown: Since 2012, President Xi Jinping’s anti-corruption campaign has pushed droves of wealthy individuals to move their assets out of China, sometimes even by illicit means.
The response from China has been a sharp tightening of capital controls in the country. Banks were ordered to limit the use of US dollars, particularly in Shenzhen and Shanghai where the demand had spiked. SAFE, the state organ responsible for regulating the country’s FX reserves and market activities, ordered banks to strengthen checks on FX deal limits.
In order to further stem the money outflow, attribution quotas for investment programmes (QDLP and QDII) have also been put on hold, while the updated programme for domestic investors to invest in equities abroad, known as QDII2, has been temporarily shelved.
Notwithstanding China’s efforts, capital outflows are likely to continue in the short term, albeit at a relatively slower pace. Market commentators have indicated that more than US$500 billion could be pulled out of China towards the end of 2016 as a result of the RMB’s continued depreciation against the US dollar, and an upward trend of outbound investments stemming from the One Belt One Road Initiative.
What does all of this mean for GPs and LPs? Here are some of our thoughts in a nutshell:
- Chinese investors will continue to look for investment opportunities abroad. In particular, we have seen growing interest from Chinese insurance companies in offshore funds ever since the Chinese Insurance Regulatory Commission (CIRC) issued implementing rules liberalising the industry’s investment restrictions in 2012. Whilst some insurance companies were faster to take advantage of these rules from 2012 (Ping An and Anbang for example), in recent months, we have seen an increase in the number of relatively lesser known Chinese insurance companies starting to look to invest into alternative assets such as PE funds. While their commitments so far have been into the large and mega-sized “brand name” buy-out funds in mature and well-established geographies and markets, we expect that insurance companies will begin to take an interest in small to mid-size funds and also emerging markets as they become more familiar with the CIRC’s outbound investment administrative processes and more comfortable navigating the private equity funds landscape.
- Chinese GPs will find it difficult to raise USD funds from Chinese investors. Tightened capital outflow controls are hampering the ability of Chinese GPs to raise USD funds from Chinese investors. GPs with USD-denominated funds may have better luck fundraising with non-Chinese investors or with Chinese investors who currently have USD accounts offshore until the SAFE and the PBOC relax their capital controls.
- Hesitation to invest in China will persist in the short term. Recent fund manager surveys identify Asia as the region most shaken in terms of global investor confidence, and the area in which most fund managers plan to decrease their investment. As we noted in our previous edition, legislative and regulatory changes have been introduced in China to promote greater international funds’ investments in the country (the “New Rules”). While the New Rules are promising, more cautious investors may wait and see how the New Rules play out before gaining more confidence.
- LPs will be more active in the secondaries market. From a global perspective, secondary transactions are increasingly being seen as a viable alternative to rebalancing and reconfiguring portfolios. GPs in the region should take particular note of this opportunity if their Chinese LPs are finding it difficult to remit money out of China.
- Different investment strategies will become increasingly attractive. We may see different investment strategies utilized such as an increase in distressed asset acquisitions in the basic materials industry, as Chinese investors may plan not to extract these assets in the short-term but keep them as long-term investments. A prime example is KKR’s partnership with China Orient Asset Management Corp. to invest in credit and distressed assets in China given “increased macro and funding challenges”.
In the past 12 months, KWM International Funds Team has advised more than 25 GPs in the Asia Pacific on closed and on-going funds, and have also acted for more than 40 LPs on their investments into offshore funds in the region. Please feel free to reach out if you would like to discuss any opportunities to work together.