A reality check on China

by Michael Greeley, contributor

What a fascinating week to be traveling in Asia. President Obama is here for the G20 Summit – as is Tiger Woods – and frankly I am surprised at how tough the local press is on both men (at least one is well deserving of the criticism though).  The juxtaposition to when I was here right after President Obama won the election – and could do absolutely no wrong – is striking.

Undoubtedly this part of the world is booming – and even that is an understatement – but I want to offer up a more nuanced perspective on what is going on here. I grew up in Hong Kong and have been blown away by the transformation this place has witnessed since I was a child. I arrived late last night from Australia and it was like mid day on the streets. The sense of vitality and optimism is present everywhere and with everyone I speak to.

I just listened to David Bonderman, founder of TPG Capital, share his impressions of the region for private equity and venture investing as the keynote speaker at the Asian Venture Capital Journal’s annual investor conference. He was followed by a parade of industry luminaries – both GP’s and LP’s. The over 1,000 participants here are all trying to figure out how to play “the Asian angle.” Bonderman left the audience with a fascinating observation – there are 243 cities in China with over 1 million people – implying that the growth will continue for a long long time.

To a person here, there is great enthusiasm. The top line growth – both in GDP and capital flows – is staggering and well documented. And it appears to be happening across nearly every industry sector. For instance, the head of Astrazeneca (AZN) China stated that the Chinese pharma industry has grown at 20% per annum the last 4 years and is not expected to slow any time soon (it is now estimated to be $20 billion).

But let me offer some concerns that I have been thinking about which may check some of the unbridled enthusiasm.

• Too much of a good thing is often a bad thing: There is estimated to be around $40 billion of committed but un-invested private capital in Asia right now (which compares to around $400 billion in the US).  Recall that private equity is effectively “temporary capital” and at some point seeks to be monetized. There is a velocity with this capital which can whipsaw a marketplace. The dynamics and expectations around private capital may be novel and entrepreneurs in region may not fully understand these behaviors.

• Overbuilt: This observation relates to the first concern and that is – can the region absorb these rapid capital inflows? Apparently there are now over 100 car companies in China; that simply is an inefficient approach to building an auto industry and will lead to painful – and inevitable – consolidation. It is widely believed that most private Chinese companies are only marginally profitable – or worse yet, consistently lose money. As the dramatic inflows of equity continue, the return on equity will be modest to unattractive. At some point investors will seek better returns elsewhere. This has worked to date because the inflows have masked poor underlying operating performance.

• Liquidity: There is a robust and emerging (i.e., untested) local IPO market coming of age. Importantly though there is scant evidence of a meaningful local M&A marketplace; double digit million sales are considered very rare. This is due to a relative dearth of local public companies and an immature acquisition financing market. There are ultra-low interest rates (real interest rates are probably negative); this is leading to certain asset bubbles – particularly in real estate and public equities. This is not sustainable.

• One Child Policy: I can’t help but think that the labor market demographics will be challenging over the next decade or two with a rapidly aging population having to be supported by the generation created under the “One Child” policy. Just something to contemplate.

• Management Talent: A common concern expressed by local investors has been the consistent lack of proven management talent (this unfortunately is not necessarily unique to Asia). Scaling a private business profitably is very challenging and it is a relatively recent phenomenon in Asia to have companies privately backed needing to manage such growth.

• Revolution of Rising Expectations: The ever present political and social concerns remain and will be exacerbated by any disruption to these enormous capital inflows. There has been a reasonably predictable cycle of economic shocks to the Asian markets – and while the enthusiasm espoused this week make these concerns feel quite remote, don’t those fears always seem remote?

One last observation: it certainly appears that the US VC industry has successfully exported itself to Asia – although most of the GP’s here are not expats.  This has troubling implications for the US VC industry – if fundamental R&D is outsourced to Asia, then who do we invest behind? We need policies which will ensure that the US maintains its leadership position in innovation.

I love it here. Don’t get me wrong. The upside is enormous and real but there are also real structural issues that seem to be overlooked in the current dialogue.

Michael Greeley is a General Partner at Flybridge Capital Partners focused on information technology, healthcare and medical technology investments. His blog is On the Flying Bridge.