The growing opportunity in China’s private markets


Two powerful trends are converging - companies are increasingly realizing the potential of private financing arrangements, while global investors are looking to put capital to work in Chinese markets.

Mark Everitt, Head of Investment Research and Strategy for Blackrock Alternative Investors, recently led a discussion on the trends, challenges and opportunities in Chinese private markets, with a particular focus on the credit and real estate markets. We present highlights below. Participants were Connie Peng, Head of China, Global Real Estate; Celia Yan, Head of China and Co-portfolio manager of the Asia Pacific Private Credit; Mike Dennis, Head of Alternative Strategy and Capital Markets for Asia-Pacific.

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We really are at the right time to get more involved in China.

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Mike Dennis Head of Alternative Strategy and Capital Markets for Asia-Pacific

How have Chinese private markets evolved?

When looking at the future of Chinese private markets one of the most important themes is going to be the evolution of a bipolar world, with China on one side and the U.S. on the other.

China is now pivotal to all our thinking. It’s too big of a market environment to ignore. Especially with COVID, where China was the first major world economy to return to growth, we’ve all been looking there to see what lies ahead for the rest of us.

Despite this growth, many non-Chinese investors are still underexposed to the country’s financial markets. However, the changes over the past decades have been transformational. The equity market in Hong Kong is now four times the size of the London Stock Exchange and 60% the size of the New York Stock Exchange. The average daily turnover on the Hong Kong Stock Exchange recently stood at about US$25 billion, up from US$10 billion a year before. China has the second-most unicorns (privately held startup company valued at over US$1 billion) in the world.1

There are three things at the heart of the private market opportunity:

Structural changes
Improvements to transparency and bankruptcy reforms create more opportunities.
The breadth of opportunities
A healthier and deeper market with real desire to partner with international expertise as the country builds more robust markets.
Capital structure development
China’s banking system evolves to include more flexible private financing throughout the capital structure.

First, structural reform. Many of us are used to thinking of China as having high legal jurisdiction risk and restrictive capital controls. But the Chinese government has been improving insolvency, credit protection frameworks, transparency and its restructuring regime.

For example, a new bankruptcy law allows bankrupt companies up to nine months of restructuring. And we’ve seen some defaults by state-owned enterprises, or SOEs, which have historically had access to capital based partly on political considerations. These developments pave the way for more efficient allocation of financial resources, and as such, global managers can now establish local businesses to build onshore alternative investment capabilities to target rising demands.

The second point relates to the breadth of opportunities. We’re seeing a healthier and deeper market. Private market activity traditionally was heavily skewed toward domestic investors, but now there is a real desire to partner with international expertise as the country builds deeper and more robust markets.

In the past, banks have dominated this market. But as regulators push the country toward a less bank-centric system, we’re seeing a greater understanding in corporate China of how companies can work with flexible private financing throughout the capital structure to achieve their goals.

Private credit has room to grow

Percentage of credit to corporates from non-bank channels

Percentage of credit to corporates from non-bank channels

Source: Bank of International Settlements. Accurate as of 30 September 2020.

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What are some trends in Chinese private credit and real estate?

There are currently four top trends in private credit: Demand for financing is exceeding supply; there are more opportunities for growth financing; private credit has been resilient; and credit managers and companies increasingly are working as partners.

Chinese banks tend to overlook small to mid-sized companies, but their need for financing still exists and is increasing. Corporations’ growing understanding of their private credit options is helping produce continuous demand. As a result, we’re seeing a scalable opportunity with a very attractive risk-adjusted return premium.

The second trend is opportunities in growth sectors like technd media. Private lending in China has always focused on sectors like distressed and asset-backed financing. As the service sector has grown, we’re able to fill the financing gap for those companies as well.

Third, credit proved its resilience in China through COVID-19. Private credit performance has been relatively stable, with low correlations to other markets. It has outperformed not just on return but also on risk, which we think are very important for investors facing uncertainties from both COVID and politics.

Fourth, the market is shifting to a more proactive approach to sourcing and lending. Credit managers now can work as lending partners to companies and helping generate post-investment value, bringing business expertise and sometimes a “stamp of approval” to the relationship in addition to just financing.

In real estate, with COVID-19 under control in China we expect volumes to start to recover in 2021, particularly in the office and logistics sectors.

Our view is that the impact of COVID-19 on China’s office sector will be short-term and limited. People started to return to work in April last year, and by May, occupancy was back to pre-COVID levels. While some sectors have been massively impacted by COVID, other sectors benefit from the new normal, such as online education and IT. And as China further opens its financial sector, this is an exciting market to diversify into. Considering all these factors, the impact of COVID-19 on office buildings in China should be relatively short-term.

We also are interested in logistics, which is vibrant in China as it is elsewhere. As the pandemic accelerated ecommerce, it provided strong fundamentals for investing in this sector.

What are the main positives and challenges you see?

We see three key positives influencing the private market opportunity:

Reforms improve the investor landscape, but risks still persist.
Increased demand for capital
Capital is needed across growth financing, distressed and turnaround financing.
Improved transparency
Data helps improve transparency. Development of mobile payments provide verification of sales and cash flows.

We should expect some market volatility in the near term as the government tries to improve market practices. This is good news for us because the market shocks from policy changes will create some funding gaps that we can address as private credit lenders.

We also see continued demand for capital, for growth financing and for distressed and turnaround financing. Now, we have access to a diversified base of financing opportunities to scale across different market cycles and regions.

At the same time, transparency in China is improving, especially for data verification. For example, with the development of mobile payments, it’s a lot easier to verify sales and cash flows. We also see the governance and transparency improvements reflected in the growing market share of the big four accounting firms and the international consulting firms.

Reforms and greater transparency help address some of the challenges in Chinese private credit, but we can’t mitigate all of the risk. Therefore, we need to make sure we have enough return premium, structure deals in ways that provide downside protection, engage in extensive post-investment management and keep loan-to-values low to increase our margin of safety.

Another positive development is that the first REIT was launched last year, and as more REITs enter the market it is seen as improving the liquidity of Chinese real estate. Other developments are the increase in scale and the fact that foreign direct investment is still a very key objective for all levels of government.

Considering these challenges, you have to be mindful that this is a big, complex market with its own dynamics, and there’s no substitute for deep local knowledge. The logistics market is a case point. The so-called tier one market has 26 cities, and each city has eight to nine submarkets. To understand the tier-one market, we need to study over 200 submarkets.

Final thoughts

Number one, we’re heading into an environment where China and the U.S. are increasingly becoming more separate ecosystems, and the Chinese government understands the need for international investors. Second, there’s a concern about long-term liquidity risk, but we don’t see it in the reality of owning private companies in China. For example, there’s been an explosion in IPOs both in Hong Kong and in the U.S.

We believe if investors can separate the real risk from the perceived risk, then they may stand to benefit from looking at the private market opportunities across China.

Mark Everitt
Head of Investment Research and Strategy, BlackRock Alternative Investors
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Connie Peng
Head of China, Global Real Estate
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Celia Yan
Head of China and Co-portfolio manager of the Asia Pacific Private Credit
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Mike Dennis
Head of Alternative Strategy and Capital Markets for Asia-Pacific
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