The outlook in China for private equity (PE) investors to earn acceptable returns remains uncertain following the recent reopening of the initial public offering (IPO) market after a 15-month freeze. Wharton experts predict tough days ahead for PE investors in the country as price wars for attractive investment opportunities threaten to erode the outsized returns PE firms typically seek.

Initial reports, nevertheless, look favorable. The 48 IPOs listed on the Shanghai and Shenzhen exchanges in the first quarter posted record returns, averaging 54% above listing price compared to 9% for the rest of the world, according to a recent Bloomberg report.

But that IPO cheer looks likely to be short-lived as other concerns mount. On May 20, China’s securities regulator said it would limit IPOs to 100 through the end of this year. Even before that announcement, other, market-related limits had the potential to discourage activity. For one, too much money is chasing too few deals, observers say. Many PE investors, including the government, are flush with funds. Second, a paucity of worthy investment opportunities is lifting valuations and narrowing the hoped-for level of returns. Third, the IPO market has not yet become a dependable exit. Fourth, warranted or not, fears abound over a rash of corporate debt defaults. And overhanging it all remains economic and political uncertainty.

“The uncertainty in China is as high as I have ever seen it on both economic and political fronts,” says Wharton management professor Marshall Meyer, who routinely consults with Chinese companies on management strategies. He lists the negatives: declining export growth; excess industrial capacity where steel mills are being dynamited to turn them into farmlands; a declining middle-income market; and concerns over financing care for the elderly, among other factors. Consequently, huge capital outflows from China are headed for the U.S., he says. “Why are the Manhattan real estate market and the New York Stock Exchange so robust? Money from China is flowing into the U.S.”

Meyer also cites the low-performing Chinese stock markets as downward pressure. The Shanghai Stock Exchange Composite Index has fallen 38% in the past four years, from nearly 3,500 in mid-2010 to 2,025 as of May 21, 2014. “I don’t see relief in sight, which means the Chinese equity markets could continue to stay in the doldrums or worse,” he adds. “In retrospect, this might be the period of the great naturalization of the Chinese economy.”

An IPO Bubble?

That process of naturalization isn’t occurring yet with China’s capital markets, according to Xu Han, a visiting management professor at Wharton, whose expertise covers entrepreneurship, venture capital and corporate governance in China. Han is unimpressed by the record returns logged by the rush of IPOs in the first quarter. He attributes the surge in the stock prices underpricing because of “implicit” regulatory constraints on IPO valuations.

“The uncertainty in China is as high as I have ever seen it on both economic and political fronts.” –Marshall Meyer

The new IPO rules unveiled by the China Securities Regulatory Commission (CSRC) set criteria for how much a stock’s price-to-earnings ratio (or P/E ratio — market price divided by annual earnings per share) could deviate from its industry average. The regulator also requires commitments on future performance from the controlling management of firms making IPOs. Some analysts credit the IPO boom to pent-up demand, while others describe it as a bubble. Earlier this year, many industry watchers had also feared that the reopened IPO market could cause the equity markets to heat up too fast, lifting valuations to unrealistic levels.

“If I were to be a private equity investor in China today, I would be worried,” says Wharton professor of entrepreneurship Raphael (Raffi) Amit. He feels the high returns investors in the last quarter’s IPOs enjoyed are unsustainable. China has not had an IPO for more than a year, and Chinese investors have “very few investment outlets,” he points out. “Further, the Chinese have one of the highest savings rates in the world, due in part to mandatory early retirement regulations and low social security payments.” Hence, when the “flood gates” opened early this year for IPOs, there was “enormous demand” for that investment opportunity, he adds.

Amit encourages observers to learn from history in setting returns expectations for investing in China. He points to ChiNext, China’s equivalent of Nasdaq for technology stocks, which surged when it opened in 2009, but has since collapsed. In a recent paper titled “VC/PE Industry in China: The Changing Landscape,” he says returns on the ChiNext have been disappointing for PE investors over the past two years.

The average P/E ratio at IPO for firms listed on the ChiNext fell by two-thirds from 93 in January 2011 to about 31 by November 2012, when the IPO market shut down, Amit shows in his paper. As of October 2012, 65% of the 355 companies listed on the ChiNext traded below their issue price.

Regulatory Concerns

Before the freeze, China’s IPO market was the second biggest after the U.S., and raised $16.4 billion from new listings in the first 11 months of 2012. At one point, some 900 companies of varying credentials had planned IPOs. The CSRC feared that a flood of new listings would dampen sentiments and suck out liquidity from the markets. It shut down the IPO market in October 2012, citing excessive pricing and inadequate disclosure of risks by some firms going public, and ordered fresh checks of IPO proposals.

The IPO freeze hurt companies looking to raise new capital and PE investors that wanted exit options. The CSRC lifted the freeze in January 2014, introducing reforms aimed at providing a greater role for market forces. The move lifted the hopes of some 700 IPO aspirants that they could finally raise money and stimulate new PE deals.

However, the cheer in PE circles after the reopening of China’s IPO markets has been short-lived. Han notes that after the initial rush of the 48 IPOs in the first quarter, no new offerings have hit the market since February 19. “It is widely believed that it is because CSRC is not happy with the results of its new policies,” he says. The CSRC has said that it would initially approve only about 50 IPOs and that it would need about a year to complete checks on the other applications.

Meanwhile, more investors have headed to the equity markets. Since 2007, the Chinese government has removed barriers to entry for new venture capital (VC) and PE investors. The VC/PE industry now includes foreign investors, securities companies, commercial banks, investment banks, corporate venture capitalists, insurance companies, angel investors and the government. Amit points to new entrants including the state-owned financial services firm Guosen Securities, commercial banks like China Everbright Bank, insurance companies and the growing number of angel investors. In addition, China’s National Council for Social Security Fund received permission in 2008 to invest up to 10% of its assets under management in private equity. The presence of so many investors has “intensified the competition” for deals, he adds.

Higher Valuations, Lower Returns

Amit estimates that the total pool of capital available for PE deals is in excess of 300 billion RMB (about $50 billion). However, he says PE investors have been able to invest no more than 150 billion RMB ($25 billion). “So, they raised more money than they were able to deploy.” That situation puts pressure on the general partners at PE funds to deploy their capital, he adds. “To do that, they will have to pay higher prices. As a result, the cost base will go up and the returns will go down.”

“If I were to be a private equity investor in China today, I would be worried.” –Raphael (Raffi) Amit

Deal values will increase also with the increased competition among PE investors for investible opportunities, notes Amit. The due diligence exercised in many of those deals is also suspect as many new PE players are “not that well educated or experienced in investing in private equity,” he notes. He expects many PE exits this year, especially since there were no IPOs last year. However, he is unsure if the market has the depth to absorb all the PE exits that are being planned.

According to Han, the PE market in China has always been about too much money chasing too few deals. “This is an 80-20 industry – 80 chasing 20,” he says. However, he sees an increasing number of startup firms in China, with the government removing many barriers for corporate registration such as minimum requirements of capital in a bank. With that, the pool of investible opportunities for PE investors will increase, he adds.

In March, China’s capital markets had another cause for worry with the specter of corporate bond defaults. Shanghai Chaori Solar Energy, a small solar power firm, failed to meet interest payments on a debt instrument it sold two years ago, making it China’s first domestic corporate bond default. Soon after, a second company called Haixin Steel defaulted on bank loans. Those defaults prompted China’s Premier Li Keqiang to warn that the country was likely to experience a number of defaults because of the government increasing financial deregulation, according to Chris Wright of Forbes magazine in a recent blog post. “If there is a chain reaction, the stakes are high: China’s bond market is worth $4.2 trillion, and its corporate bond component over $1 trillion,” he writes, adding that he hopes the defaults will eventually make way for improved market health and governance instead of triggering a crisis.

According to Meyer, the debt-default threat will test China’s “too big to fail theory.” He says the Chinese government recognizes that the cycle of borrowing to meet GDP growth targets “can only be disastrous,” and that it is therefore asking banks “not to lend too much.” Earlier, companies that landed in financial trouble could expect to get more lending support, but those days are ending. “[The Chinese government] is testing the waters to see how much failure the markets can tolerate.”

Riding out the IPO Embargo

Like in any other market, PE funds focused on China make profits, or exit, by cashing out on their investments when the investee firms go public with an IPO. They also exit by selling their stakes to other PE funds (called “secondary sales”) or “strategic investors” through M&A deals (called “trade sales”).

Despite the freeze in China’s IPO market, PE investors saw a surge in deal value to $35 billion in 2013, according to a PricewaterhouseCoopers PE market analysis. Thirty-five Chinese firms headed overseas, listing their IPOs in the Hong Kong and U.S. stock markets.

China’s IPO freeze last year drove many PE and venture capital investors to find exit options in M&A deals with other strategic investors. PE firms also last year completed exits worth $6.4 billion through M&A deals or trade sales to strategic investors, which was double the figure from 2012, according to Thomson Reuters. They also concluded $346 million worth of secondary sales to other PE investors, although that total was 51% lower than in 2012.

However, between 2012 and 2013, PE investments in China nearly halved to $4.5 billion in 198 firms, according to data from Thomson Reuters. That was consistent with a 46% decline in private equity deals across Asia Pacific (excluding Japan) at $11.4 billion in 2013. Chinese companies, however, led the Asia Pacific market for PE deals that year with a 39% share, followed by India with 27%, or $3 billion.

New Investment and Exit Avenues

While the uncertainty with the IPO markets continues, China has opened up other avenues for small businesses to raise capital. It recently allowed all qualified small businesses to raise money through its over-the-counter (OTC) stock market, called the National Equities Exchange and Quotations System. That OTC market was hitherto restricted to firms in four high-tech zones in the country, including Beijing’s Zhongguancun Science Park.

Chinese firms listed in Hong Kong or elsewhere offer easier exit opportunities for PE investors. In early April, Morgan Stanley Private Equity Asia launched a sale of 120 million shares in Hong Kong-listed Sihuan Pharmaceutical Holdings that could be worth up to $147 million. In another deal announced in April, Canadian theater operator IMAX said it would sell 20% of its Chinese business to two China-focused PE investor groups for about $80 million, who in turn plan a Hong Kong listing in 2015.

Private equity investors “raised more money than they were able to deploy.” –Raphael (Raffi) Amit

Investors in China are now closely watching the IPOs from two Chinese technology companies in U.S. stock exchanges. Chinese e-commerce giant Alibaba plans a $15 billion offer. The IPO would value Alibaba at about $140 billion, eclipsing the $102 billion valuation for Facebook when it went public in May 2012 with a $16 billion offering. Micro blogging site Sina Weibo that is 18% owned by Alibaba raised $286 million in its IPO in mid-April on Nasdaq, significantly lower than its original target of $500 million. However, Weibo’s IPO is considered successful; its share price rose nearly 20% over the $17 offer price on its first trading day, lifting hopes for Alibaba’s debut. Others in line for a U.S. listing include Chinese e-commerce company that plans a $1.5 billion IPO.

As PE funds hunt for deals, they might find opportunities among China’s state-owned enterprises, or SOEs. “While state-owned enterprises account directly or indirectly for 60% of China’s GDP, almost 100% of institutional capital, especially private equity, has been invested into China’s privately owned sector,” writes Peter Fuhrman, chairman and CEO at Shenzhen-based investment bank and advisory services firm China First Capital in a recent blog post.

According to Han, China’s SOEs have had easy access to bank loans, but many of those are not as efficiently run as private companies are, and may have serious problems with debt. However, a shakeout in the SOE sector could provide opportunities to clean up the economy and present opportunities for PE investors to buy distressed assets, he says. The quality of those assets might appear bad at first sight, but in many cases, they could turn out to be profitable with improved managerial capabilities, he adds.

Resetting the Markets

Han lauds the CSRC for its efforts to make the IPO market more efficient, transparent and protective of minority shareholders. Under the new regime, the CSRC will allow market forces to determine the timing and pricing of IPOs, and retain mostly a policing function and exercise a veto on which companies can go public. It has new rules governing issue pricing that include stringent penalties for violators. To check runaway IPO values, it requires a two-year lock-in for controlling shareholders. Those that provide misleading disclosures will be forced to buy back the shares so issued. Underwriters could have their licenses suspended if they back IPO companies whose profits fall 50% or more in the first year of going public.

As China’s capital markets evolve, they could learn valuable lessons from the U.S. markets, according to Han. They can learn how to leverage corporate governance mechanisms such as instituting independent directors, addressing agency problems (or conflicts of interest) and ensuring accuracy of disclosures in companies, he explains. “In China, these corporate governance mechanisms are not as efficient as in U.S. companies.”

Han says China’s PE and venture capital market has grown too fast for comfort in recent years. Many PE investors provide capital and engage in price wars for deals, but they also need to provide managerial capabilities to early stage companies, he adds. “A period of consolidation to weed out incapable players might be good to bring the industry closer to its original function.”

According to Han, China’s PE markets need longer-term, structural changes. “What can truly lead to a more durable revival of the market are a mature institutional infrastructure and a solid economic basis,” he says. “For the moment, both are veiled [in] uncertainties.”

That assessment resonates with Meyer’s bearish assessment of China’s economic prospects. Last month, on a plane as he returned to the U.S. from one of his regular China trips, he found himself seated next to an entrepreneur “trying to get some money out of China.” His co-passenger talked about a massive anti-corruption drive the Chinese government had launched, and fears about where the axe would fall next.

“People are afraid to be seen in expensive restaurants, and they are closing down left and right,” says Meyer. His favorite example is that of the famous Maison Boulud restaurant in the former American Embassy in Beijing, which closed down last December. A New York Times story chronicling Maison Boulud’s history recalled how a Chinese businessman once paid his $23,000 restaurant tab. He called for his driver, who delivered two bags filled with Chinese bank notes. That would be unthinkable in today’s relatively more austere China, and like others, private equity investors must adapt to a measured pace.