Private-Equity Funds in China Continue to Grow Despite Wider Economic Slowdown

Some international private-equity firms investing in China are choosing to denominate new funds in the country’s local currency, despite a slowdown in global demand for bets on Chinese startups. This move allows these firms to take advantage of the Chinese market’s potential for growth.

The appetite for allocating capital to funds focused on China has waned over the past year, the result of factors including tensions between Beijing and Washington, higher U.S. interest rates and a prolonged crackdown on China’s once-hot internet sector. These factors have made investors more cautious about investing in China, leading to a decrease in capital allocations to China-focused funds.

The amount of U.S. dollar capital raised by China-focused private-equity funds plunged more than 80% to just under $23 billion in 2022, according to data from Preqin Pro. This is the lowest amount raised since 2010.

Yuan-denominated funds have held up much better. The equivalent of around $455 billion was raised by yuan funds in 2022, just 4% down on the year before, according to data from Zero2IPO, a Chinese private-equity data provider.

In October, L Catterton, a private-equity firm focused on the consumer sector, announced that it is planning to raise the equivalent of $295 million for its maiden yuan-denominated fund. The fund has completed a first round of fundraising, according to a statement on the firm’s WeChat account.

Schroders Capital, a unit of Britain’s Schroders PLC that focuses on private assets, has launched four yuan-denominated fund-of-funds since 2020. The fourth fund is in the process of raising money from investors. At least two more global money managers are raising cash for their own debut yuan funds, according to people familiar with the matter.

The yuan funds are in high demand from both local and international investors. L Catterton's new investment vehicle has secured funding from Chinese government-backed funds, local consumer companies, and multinationals. The global firm, which manages over $30 billion and counts LVMH Moët Hennessy Louis Vuitton SE's chairman Bernard Arnault as one of its backers, has previously taken stakes in popular Chinese consumer brands such as Genki Forest.

Schroders Capital's yuan-denominated funds have invested in established, China-based private-equity firms such as Sequoia Capital China and Legend Capital. These firms have a proven track record in the Chinese market and offer a wealth of experience and expertise. Schroders Capital is confident in their ability to generate strong returns for investors.

As more and more sophisticated investors look for ways to hedge their portfolios, the RMB market is becoming increasingly attractive. Jun Qian, head of private-equity investments for China at Schroders Capital, notes that this is due in part to a slowdown in allocations to the USD market.

In the past year, many Chinese private investment firms that previously relied heavily on raising capital from the likes of U.S. pension and endowment funds have seen a drop in demand. Only about half of the investors in private-equity funds are committing to follow-on fundraising rounds, said Niklas Amundsson, a Hong Kong-based partner at Monument Group, which helps private-equity firms raise money.

According to Scott Chen, a managing partner in the Asia fund of L Catterton, the decision to denominate funds in the yuan can help private-equity funds invest in companies at an earlier stage. The majority of Chinese consumer startups only seek yuan in their first few fundraising rounds, which gives the fund potential to make outsize gains compared with those investors who join later funding rounds.

Investing in Chinese consumer companies in yuan can have a number of benefits, one of which is that many of these companies eventually seek listings on the domestic A-share market, which is traded in yuan.

Schroders Capital focuses on three themes when looking for funds that invest in Chinese startups: consumer, digital enterprise solutions and import substitution. The latter refers to strategic sectors such as semiconductors, where China is trying to reduce its reliance on foreign parts.

Although there are no restrictions on dollar funding in the semiconductor sector in China, companies in the industry are increasingly opting to take funding in yuan. This is because they are likely to receive a more favorable reception in the domestic market when they go public.

The choice of the yuan does have challenges. Government-backed funds, a crucial source of capital, often demand that money managers push their portfolio companies to invest in the local economy—a practice known locally as “reverse investment.” This can be agreed upon before any commitment to fundraising. They also often want to directly invest in companies alongside the private-equity funds, rather than accepting a role only as a passive investor in the funds.

This isn't the first time that international private-equity firms have tried to raise and invest in yuan. In the early 2010s, global giants including Carlyle Group Inc. and TPG Inc. attempted to raise yuan funds to scout for buyout or minority investment opportunities in Chinese companies. However, the results were underwhelming and many of them have since ceased managing or drastically cut back their yuan presence.

Some market participants argue that the current landscape for private-equity investments in China is different from in the past, due to the increasing opportunities to invest in startups. They believe that this difference makes the current market situation unique.

"The type of deals that were available to the mega funds were generally non-controlling stakes in mature companies," said Mr. Amundsson of Monument Group. "Today, the opportunity set is different, and it's possible to make great returns on these types of investments."