It wasn’t long ago that China was the darling of private equity. Whether it was seeking Chinese investors for their funds or staring googly-eyed at the prospect of expanding their portfolio companies into a market with over a billion people, a “China strategy” was front-and-center for most middle-market and larger PE firms.

Things couldn’t be more different just a few years later, with regulators keeping a watchful eye on any PE involvement with the Red Dragon. How did we get here, and what will the future hold?

Last summer President Biden issued an Executive Order explicitly banning investments by U.S. businesses in “national security technologies” in China. The order, which comes amid growing fears of Chinese military expansion, targets quantum computing technology, semiconductor design and production, microelectronics and any artificial intelligence software aimed at the Chinese military, government intelligence or mass surveillance.

Geopolitics and mutual distrust between Washington and Beijing have led to moves by both sides to tighten restrictions on foreign investment, while China’s internal crackdowns on the tech sector have also forced Western funds to rethink their business plans for the country.

A key moment was China’s 2020 decision to block domestic financial services giant Ant Group from going public, which deprived U.S. private equity backers including Carlyle and Warburg Pincus of a lucrative exit.

The focus on U.S. investments in China represents a pivot for regulators, after years of bearing down mainly on Chinese investments in the U.S. and the acquisition of Western technologies. But it is likely only a beginning and the ban may be extended to other technologies, according to research consultancy Rhodium Group, which says there is “room for scope creep” to include biotechnology, advanced sensors and large-capacity batteries, for example.

Private equity firms and strategic investors alike were taking a more cautious approach to Chinese business well before the White House intervened.

Rhodium Group says a growing share of EU, U.K., U.S. and Japanese firms do not plan to increase investment in China in the coming years, and points out that geopolitics is not the only driver of moves to disinvest, or at least diversify away from China. It says a deteriorating business environment and rising competitive pressures are also pushing the likes of South Korea’s Samsung Electronics and LG, and Chrysler and Jeep maker Stellantis Automobile Corp. to exit China “amid declining market shares,” and announce investments elsewhere.

That does not mean that China is now off limits for all investment. Rhodium believes that diversification will happen much faster in sensitive sectors, while the “persistent attractiveness of China as a manufacturing hub will remain a drag on diversification efforts.”

There is a growing view both within the U.S. government and private industry that a full “decoupling” of the U.S. and Chinese economies is unrealistic and the emphasis now should be on “de-risking” the relationship instead.

“Everyone wants to keep the doors open and they want to continue to do business,” Emily Benson, project director on Trade and Technology at the Center for Strategic and International Studies, says. “But it’s politically becoming more difficult to do that, because there’s a bipartisan consensus emerging in Washington about China less as a customer and more as a threat.”

Still, investors hope to keep a foot in the door by staying away from tech and concentrating on China’s growing domestic middle class of 400 million consumers.
KKR co-CEO Joseph Bae said as recently as July that the New York firm has about $6 billion invested in China and has been putting its money in domestic consumer goods, from pet food to liquor and lighting fixtures, rather than sensitive technology. “Our core focus has really been around the sweet spot of what we think the market opportunity is – domestic consumption,” he told CNBC Asia.

Even while investors are cautious, some big U.S. firms, including Blackstone and KKR, have been able to set up China-based fund management units. These have received quotas under the qualified domestic limited partnership program, or QDLP, to raise funds from Chinese institutional investors and high net worth individuals for investments in foreign assets.

Raising Funds from Chinese Investors

However, a look at the fundraising landscape over the past decade shows that Western interest in Chinese capital has been in decline for years. Washington’s increasing restrictions on China-based investors putting money in the U.S. has long raised fears that even having a Chinese investor on board in any new PE deal may struggle to get approval.

Niklas Amundsson, Hong Kong-based partner at placement agent Monument Group, says U.S. firms’ post-financial crisis enthusiasm for raising commitments from Chinese sovereign wealth funds had already “tailed off” in the mid-2010s. GPs had begun to worry that Washington’s regulator, the Committee on Foreign Investment in the U.S. (CFIUS), which gained extra powers under President Donald Trump, might look askance at large amounts of Chinese state funding for investments in U.S. companies.

“Even before Covid, we had clients saying ‘we don’t want Chinese sovereign entities investing in our funds for CFIUS reasons,” says Amundsson. “That started several years ago. My last fundraising trip with clients to Beijing to meet with sovereigns there was probably in 2018.”

In its recent Asia Pacific Private Equity Report, consultancy Bain & Co. points out that capital raised by Greater China-focused funds fell from $290 billion in 2017 to $208 billion in 2018 to $113 billion and $107 billion in the Covid-19 years 2020 and 2021 before dropping off a cliff to reach just $25 billion last year.

“One reason was foreign LPs’ sharply diminished interest in China given the country’s uncertain economic outlook and U.S.-China geopolitical tensions,” the Bain report says.
That’s making fundraising and dealmaking more complicated, according to Ropes & Gray Private Equity Partner Elizabeth Todd.

“We’re seeing a lot of hesitation, both in terms of having Chinese investors, co-investors or joint venture partners doing transactions with you or having them be anchor or material investors in your funds.

“You’re worried about doing deals, particularly in the U.S., and whether you will get CFIUS approval, but there are also concerns about other regimes like the U.K. Foreign Direct Investment and National Security regime,” she adds. “Given the current difficult market for transactions, people are trying to limit any potential factors that could frustrate or complicate deal execution.”