Ongoing trade tensions between the U.S. and China, coupled with strong policy moves, have given private equity limited partners pause and in some cases prompted divestiture of China holdings, according to industry sources.

“Certain pension plans are sensitive to these [geopolitical] issues and they try to de-risk from China,” said Sunaina Sinha, managing partner at placement agent Cebile Capital LLP. “First there were no new commitments to Chinese [general partners], then LPs sold China exposure as portfolios in the secondaries market. We’ve seen both as a trend the last 24 months.”

Fundraising for North American, China-focused private equity funds has been on a four-year decline, Preqin data shows. Despite a one year spike over that period — funds from the China-based unit of Sequoia Capital Operations LLC accounted for 91% of the 2018 total — U.S. investor appetite for China-specific funds has plunged, the data shows.

Six China-focused funds are now being raised by North American private equity firms, the largest of which is Legacy Partners LLC’s third fund, targeting $500 million. No such funds have held a final close so far this year.

The upcoming U.S. presidential election is unlikely to change investor sentiment, sources agreed. Although both candidates have a different approach — for example, Joe Biden pledges to work with allies to counter China — they both promise to take a hard line.

Ratcheting up pressure

While the coronavirus outbreak has had an impact, policy has weighed heaviest on fundraising this year. The U.S. State Department urged pension funds, university endowments, indexes, mutual funds, insurance companies, venture capital firms and institutional investors to disclose stakes in Chinese companies and consider divestment.

“The board of governors of these institutions have a moral duty and perhaps even a fiduciary duty to divest from companies that contribute to human rights violations,” according to a State Department release.

Tougher compliance rules for U.S.-listed Chinese companies are also coming. In a second statement, university endowments were warned to “divest from [People’s Republic of China] firms’ stocks in the likely outcome that enhanced listing standards lead to a wholesale delisting of PRC firms from U.S. exchanges by the end of next year.”

The statements create concern for institutional investors about exits, said Nicholas Tsafos, partner-in-charge of accounting and advisory services firm EisnerAmper LLP in New York.

“If an institutional investor is anticipating an IPO exit in the U.S. in three to five years, with the new rules if Chinese companies don’t comply then in two years these companies will not be able to be listed in the U.S., which will make it a lot harder for U.S. institutional investors to cash out. I do see [SEC compliance] as a tightening of the noose.”

More pressure comes from the forced divestment of video-sharing site TikTok from its China-based parent, ByteDance, which counts KKR & Co. Inc., General Atlantic LLC, Coatue Management LLC and Sequoia Capital’s China unit as investors.

Citing national security concerns — the risk that the company could provide the personal data of U.S. citizens to the Chinese government — the U.S. administration is forcing TikTok to transfer ownership control to American companies or face a ban.

Another look at China’s LPs?

TikTok’s dilemma raises doubts about the potential of Chinese startups to scale in the U.S. and has also prompted some U.S. private equity firms to reassess investments from state-linked Chinese LPs, according to a U.S. based placement agent who asked to remain anonymous.

China’s sovereign wealth fund China Investment Corp., or CIC, for example, partners with top private equity groups for pure investment return, “but it also involves an element of technology transfer — understanding the intellectual property that [attracts] good private equity investment,” the source said.

In the past, CIC asked if they could place interns within private equity groups in the U.S. and Europe, he said. “There is talk about [CIC] wanting to be on limited partner advisory committees, who get a certain level of information. If you’re a tech investor and consider what’s going on with TikTok, you could get a little paranoid.”

CIC has done nothing untoward and no one is declining capital from China’s LPs, he said. But he added that participation from state-linked Chinese investors is being reassessed in the context of geopolitics due to the perception of additional risk on a 10-year lockup of capital: “Would you rather take $300 million from Ontario Teachers or from CIC? Which could become more complicated over a ten-year period?”

As tensions between the world’s two largest economies play out, there is a flight to quality, said Sinha, from Cebile Capital. The largest general partners and LPs will benefit and will always find a way to invest, she said. “For mid-size, growth and venture capital, the impact will be much more severe. They will continue to see investor pullback unless there is a big policy shift on China.”

Source: S&P Global Market Intelligence 

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