Slowing growth Reports of the slowing rate of macroeconomic growth in China must be placed in context. While the rate of growth has indeed slowed from unsustainably rapid levels, it is quite robust by global standards and is likely to remain so. Indeed, as illustrated in figure 1, China is expected to account for nearly a third of all real global GDP growth in 2017.

While a country’s macroeconomic growth alone cannot produce good private equity investment performance, it certainly helps. This is especially true in China, where most of the growth is coming from private companies unable to borrow from banks or access public debt and equity financing to the same degree as in other countries.

China presents a challenge for financial investors. On the one hand, it is now the world’s second-largest economy by some measure. It continues to grow at rates well in excess of those in Europe, Japan and the U.S. It is undeniably a country on the move, one that is exciting to watch and, in our opinion, one in which investors should participate.

On the other hand, worries about the Chinese economy seem to have received more than adequate attention from the world’s financial press. There is certainly plenty to be concerned about: slowing macroeconomic growth, increasing levels of debt, a possible bubble in residential property prices, volatile public equity markets and, most recently, a depreciating currency and capital outflows.

There are good reasons to believe that the Chinese leadership will be able to manage these issues without suffering serious crisis, for reasons we discuss in this paper. In addition, we are convinced that thoughtful private equity investors can achieve attractive, risk-adjusted returns while participating in the continuing development of what is anticipated to become the world’s largest economy.

Figure 12017 Real Global GDP Growth (%)

As of January 2017. HQ Capital makes no guarantee of future outcomes and/or targets.Note: Other Emerging Markets are all emerging markets as defined by IMF excluding China. Other includes residual countries not picked up by the other three categories, namely Advanced Economics defined by IMF ex-U.S. Source: IMF, World Economics Outlook October 2016.

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Moreover, although the overall rate of growth has slowed from the torrid pace of the early years of market-oriented reforms, most of the slowdown is due to the actual decline of certain sectors dominated by state-owned enterprises (“SOEs”), which themselves account for the lion’s share of bank borrowings and public market financing.

Massive overcapacity in certain sectors dominated by the state, such as steel and cement production, is proving to be a major drag on Chinese growth. The fact that most economists predict 2017 to see growth in the range of 5-6.5% suggests that the privately-owned businesses in which our fund managers invest, such as healthcare and financial services, education and new technologies, are growing much more rapidly than the overall rate indicates.

Growing debtChina’s SOEs are a problem for the country’s economy in more ways than one. Notably, they account for a meaningful proportion of the increased level of societal debt that, having reached roughly 260% of GDP -- up from 154% in 2008 -- has caused some anxiety among international investors.

The Chinese government is also concerned about that phenomenon. Its agencies are now actively employing a number of measures aimed to control and reduce debt generally and in particular SOE borrowings, including a substantial and continuing program of swapping debt for equity. Controls on the growth of private credit in the non-bank financial sector are also being implemented. Whether such measures prove efficacious in the slow process of reforming the SOEs remains to be seen, but it is clear that the Central Government is committed to bringing the overall rate of growth in debt under control.

Some commentators have likened the growth in private credit, which has fueled a rise in real estate prices, to the situation that prevailed in the U.S. during the years immediately prior to the financial crisis of 2008. While it is true that a large percentage of China’s societal debt – which as a percentage of GDP is still only half that of Japan’s – is held by households who have borrowed principally to purchase the residential properties they occupy, there are important differences from the U.S. experience.

Most mortgagees in China have a substantial amount of equity tied up in their property, with loan to value ratios much lower than in the U.S. both before and after that country’s housing crisis. Moreover, there are no non-recourse mortgages in China. With unlimited

personal liability, Chinese borrowers tend not only to be more prudent but also more prone to refrain from selling even during a prolonged period of suffering negative equity.

It is important to note also that the majority of China’s debt is domestic. As the major domestic lenders are well-capitalized state-owned banks incented by regulation to write off bad loans, and as the finances of the ultimate owner of China’s SOEs – the Central Government -- are healthy, astute and well-informed observers such as Shan Weijian of PAG do not believe there will be a financial crisis in China or even an economic hard landing.

That is not to say there are no problems in the economy generally or the financial system in particular. Nor do we think that the resolution of such problems will be easy. But there are strong grounds to conclude that China’s debt is not going to be the problem that some observers have claimed it could be and that the Chinese economy is fundamentally stable. Stability does not produce good private equity returns by itself, of course, but when coupled with growth it certainly helps.

Exciting sectorsTurning to opportunities, it is clear that growth in the sectors in which our investment partners are currently most active – including education, financial services, and healthcare – is strong and likely to remain so for some time. This growth is due to the rise of China’s middle class, members of which have increasing amounts of income to spend and invest.

Five years ago, the number of middle class urban households in China – defined by McKinsey & Co as enjoying annual income of between $9,000 and $34,000 – reached 174 million. As figure 2 illustrates, five years from now that number is forecasted to rise by nearly 100 million households, with the percentage in the upper middle class rising nearly three times.

Figure 2The magnitude of China’s middle-class growth is transforming the nation

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to $34,000); mass middle class, 60,000 to 106,000 renminbi (equivalent to $9,000 to $16,000); poor, <60,000 renminbi (equivalent to <$9,000).3. Compound annual growth rate.Source: McKinsey Quarterly, Mapping China’s Middle Class, June 2013

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The consumption power of China’s middle class households is already very sizeable and is projected to grow rapidly in the coming half decade. Another forecast, presented graphically in figure 3, gives a sense of the scale of this consumption, with the incremental growth projected for the period 2015-2020 being roughly equivalent to total consumption in Germany and larger than in the U.K.

As Chinese households have grown in wealth, they have sought the same goods and services as people in other countries. At present, we are seeing strong appetite for better quality consumer products, including safer and healthier food; increased expenditure on leisure pursuits and experiences, including travel; strong demand for supplementary education at the pre-school level as well as vocational and language training; and an insistence on more and better healthcare products and services. Some of these powerful trends are illustrated in figures 4, 5 and 6.

Figure 3

By 2020, Chinese consumption is expected to grow by $2.3 trillion even if GDP growth slows to 5.5%. Nominal private consumption, 2020 (in $trillions)

As of January 2017. HQ Capital makes no guarantee of future outcomes and/or targets.Note: Assumes annual GDP growth rate of 5.5%. Because of rounding, not all numbers add up to the totals shown.Sources: Economist Intelligence Unit; BCG analysis, December 2015

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Figure 4China healthcare expenditure(in RMB billions)

As of January 2017. Past performance is not necessarily indicative of future results. HQ Capital makes no guarantee of future outcomes and/or targets.Source: McKinsey Report, NHFPC, SBCVC, HQ Capital Analysis

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As of January 2017. Past performance is not necessarily indicative of future results. Source: Zero2IPO, IT Juzi, Deloitte Analysis, HQ Capital Analysis

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In addition, the middle classes and the affluent in China are looking for ways to manage their finances better, protect themselves from loss and improve returns on their savings. As figure 7 shows, household financial assets in China remain overwhelmingly in cash and deposits. This can be expected to change rapidly and China is already seeing new forms of financial services developed by non-traditional players, such as internet giant, Tencent, and private equity-backed Ant Financial.

In many cases, the goods and services being sought by the increasingly affluent Chinese are not supplied at all by SOEs, or are supplied badly, with private enterprises filling the breach. Such enterprises often find it difficult or impossible to obtain finance for growth from traditional sources and therefore are the principal users of private equity capital. We look for managers who understand these trends and others, such as the growth of new industrial models and materials, and who have developed the expertise to be value-adding partners with their portfolio companies.

Challenges and opportunities, old and newOne challenge for private equity investments in China remains exits.

Many China-focused growth capital funds invested during the past decade remain unable

Figure 6Total annual Chinese outbound trips (in millions)

Figure 7Composition of household financial assets in China and the U.S., 2012(% of total)

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As of January 2017. Past performance is not necessarily indicative of future results. Note: “Other” includes wealth- management products, gold, derivatives and other assets.Sources: US Federal Reserve Consumer Finance Survey; The Economist Intelligence Unit

to divest and return capital to their investors. We believe this was due in large part to inexperience and an overly optimistic sense of their ability to access public equity markets. While the public equity markets have steadied since China’s stock market bubble and crash of 2015 and initial public offerings (“IPOs”) have resumed, the road to a domestic IPO remains long and hard for most private companies.

It is essential that private equity managers in China have the discipline and skills to find other avenues to exit their investments. Fortunately, the growth of domestic mergers and acquisitions as well as dividend recapitalizations have presented some new liquidity solutions. At the same time, troubles for existing portfolios can produce attractive opportunities for secondary investors having the requisite contacts and expertise.

As of January 2017. Source: DFS PRC Segmentation Research 2015; China Statistical Yearbook 2015; Li & Fung - Global Chinese Shoppers: Carrying Spending Momentum into 2016

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International expansion for larger Chinese companies is natural. Doing so successfully, however, whether by acquisition or through joint ventures, presents challenges that many such companies do not yet possess the human resources to meet. One way for such companies to address such challenges is to work with private equity firms, such as Hony, PAG Asia and Primavera, adept at helping to bridge gaps in skills and experience.

In summaryGlobal investors understand that China’s role in the world economy is already huge and destined to grow larger. It is also clear that it is not easy for financial investors to participate in this exciting but complex market. What should become increasingly clear is that one way for investors to allocate capital is through the thoughtful use of private equity, which as figure 8 makes plain has significantly outperformed public equity investing in China over a meaningful period of time.

We believe that there continues to be excellent opportunities in China available for granular, bottom-up investors with adequate resources on the ground and experience of the market. Volatility elsewhere in the world and an overly simplistic approach to debt and slowing macroeconomic growth in China have obscured those opportunities for many investors. We believe this has made the environment all the more attractive for those able to see past headlines and exploit the opportunities presented by inefficient and relatively opaque capital markets in the region.

Of course, the key to successful private equity investing in China, as elsewhere, is to work with local partners who have relevant expertise and experience and whose interests are properly aligned with those of their investors.

In addition, private equity investors in China face a couple of new challenges, to which they and their local investment partners must be attentive.

The first challenge is the rise of domestic currency funds, in some cases sponsored by government agencies but also funded by domestic individual investors looking to diversify from public equities and real estate. These funds, which are often structured and managed very differently from those more familiar to international investors, have in certain sectors driven up entry valuations to unsupportable levels. Dollar-denominated funds cannot compete with such funds on pricing and therefore need to win by demonstrating superior ability to add value to the company in which they are investing. Fortunately, we believe Chinese business owners are becoming more discriminating in this regard.

A second challenge has to do with China’s currency, the renminbi, which is likely to depreciate in the year ahead. While China’s central bank is unlikely to surprise the markets with a sudden move, as in 2015, policymakers do see the need to let the currency fall against the U.S. dollar. Although the renminbi has fallen less against the dollar than the pound or the Euro during the past three years, this is due in large part to the efforts of the central bank. It seems likely that the combination of a gradual weakening of the currency and much stricter capital controls will continue, requiring managers to underwrite appropriately and hedge when doing so is economical.

On the opportunity side of the ledger, we are seeing a growing number of control transactions and international expansions involving Chinese companies and private equity sponsors.

The control deals arise because some sectors are becoming increasingly ripe for consolidation. In addition, the entrepreneurs who created China’s first private companies are growing older.

Many will likely seek to sell their businesses as the dream of an IPO fades and when confronted with health and succession issues.

Figure 8Index Performance of Different Asset Classes in Asia(Indexed return)

As of January 2017. Past performance is not necessarily indicative of future results. Source: Cambridge Associates LLC Asia & Pacific PE & VC returns are pooled end-to-end returns, net of fees, expenses and carried interest. Based on data compiled from 447 Asia/Pacific private equity (buyout, growth equity, private equity energy and mezzanine funds), and venture capital funds, including fully liquidated partnerships, formed between 1986 and 2015; FactSet

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HQ Capital has a well-established presence in Asia, with two offices in China and a seasoned local team. Through our various investment programs, we seek to help investors build well-constructed private equity portfolios through a combination of primary commitments to funds and the acquisition of interests in the secondary market, managed by partners having the qualities we believe essential for success.

For further information about our programs, please contact us.

Important Disclaimers and Performance DisclosuresGeneral: The information contained herein regarding HQ Capital is confidential and proprietary and intended only for use by the recipient. The materials may not be reproduced, distributed or used for any other purposes. The information contained herein is not complete, and does not contain certain material information about alternative investments, including important di-sclosures and risk factors associated with an investment in these types of vehicles, and is subject to change without notice. This document is not intended to be, nor should it be construed or used as, an offer to sell, or a solicitation of any offer to buy, shares or limited partner interests in any funds managed by HQ Capital. If any offer is made, it shall be pursuant to a definitive Private Placement Memorandum/Offering Memorandum prepared by or on behalf of a specific fund which contains detailed information concerning the investment terms and the risks, fees and expenses associated with an investment in that fund. Neither the Securities and Exchange Commission nor any state securities administrator has approved or disapproved, passed on, or endorsed, the merits of these securities.Performance: The performance information herein has been prepared by or on behalf of HQ Capital, and has not been independently audited or verified except for certain year-end data. Investment returns may vary materially from the stated objectives and/or targets so that investors may have a gain or a loss when they redeem their investment. As with any investment vehicle, past performance cannot assure any level of future results. Forward looking statements constitute the opinion of HQ Capital. HQ Capital does not guarantee any specific outcome or performance.Risks: Investments in alternative investments entail substantial risk and should not be intended as a complete investment program. The profitability and return of alternative investments are dependent upon numerous factors, which may include the active management of securities, across global markets. There are no opportunities for redemptions and transferability of interests in alternative investments may be limited so investors may not have access to capital when it is needed. Alternative investments are designed only for sophisticated investors who are able to understand the scope of and bear the economic risk of losing all of their investment. Alternative investments: (1) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; (2) can be highly illiquid; (3) are not required to provide periodic pricing or valuation information to investors; (4) may involve complex tax structures and delays in distributing important tax information; (5) are not subject to the same regulatory requirements as mutual funds and other publicly traded securities; and (6) often charge high fees.Current information: Opinions expressed are current opinions as of the date appearing in this material only. The information provided in these materials is illustrative and no assurance can be provided that any of the future events referenced herein (including projected or estimated returns or performance results) will occur on the terms contemplated herein or at all. While the data contained herein has been prepared from information that HQ Capital believes to be reliable, HQ Capital does not warrant the accuracy or completeness of such information. The underlying managers used by HQ Capital in its portfolios are subject to change in the future and there will likely be additional managers added to the portfolio.Use of indexes (where applicable): Market index information shown herein is included to show relative market performance for the periods indicated and not as standards of direct com-parison. The market volatility, liquidity and other characteristics of the Fund’s portfolio composition are materially different from securities listed on public market indices. Market index information was compiled from sources that HQ Capital believes to be reliable. No representation or guarantee is made hereby with respect to the accuracy or completeness of such data.Index definitions (where applicable): The MSCI AC (All Country) Asia Pacific Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed and emerging markets in the Pacific region. The Shanghai Stock Exchange Composite Index is a capitalization-weighted index.

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About the Author

David PierceManaging Director, Head of Asiadavid.pierce@hqcapital.com