China and private markets

Josh Lerner: So I have two pieces of bad luck, one of which is, of course, being the last person before lunch. The second is that I feel like there's been a long lineup of very depressing topics. We did, you know, Terra Luna, you know, the old men running for president. That's not so great. I gather over lunch. It's the Red Sox, which is another extremely, extremely depressing topic. Right? So it's a real loser. And I was like, you know, I am such an idiot. I could have done my talk about India and we could be really upbeat and positive. And somehow, foolishly, I ended up choosing China to talk about instead. So I will try to be as cheery as I can, but with the caveat that it is a bit of a challenging, a bit of a challenging time. There I was. I did a little tour through there a couple of weeks ago and met with a bunch of our alumni, you know, most of whom were not full of joy and goodwill to mankind, even though I guess they were glad to see me. But it still wasn't it wasn't the sort of greatest time. So let's start with the happy stuff, which is what happened in the 20 tens. Then we'll turn to the 2020s, which is not so not so great. I may may resist the temptation to I'm a nerd, so I'm always like wanting to sort of bring in a bunch of academic stuff.

I'm going to go very quickly through that and then just sort of turn to the turn to the future and think about some of these some of these some of these issues. All right. One thing we know is there's a lot more private capital today than there used to be. Right? So if you look worldwide at venture buyout growth, private credit and stuff like that and sort of look across the, you know, the various various strategies. Right. We're throwing co-investments and real estate in here as as well. Right. It goes from, you know, essentially, you know, just this, you know, half a trillion to around 9,000,000,000,000in 20 years. So really extraordinary growth. And we could spend a lot of time just thinking about what's behind that sort of hypergrowth in terms of private private investments. But we know that this has been one of the sort of dominant investment stories of the 21st century so far. And in some sense, China has not been the exception here, that they've really sort of rode the the wave, that the same kind of growth that we've seen in terms of the in terms of the the the the Blackstone's and KKR here in the States and in Europe and so forth has certainly been experienced both by dedicated Chinese investment managers as well as global global managers with a footprint in footprint in China.

If this has been true in across private markets, where it's really been true is in in in venture capital activities. Right. That when we look at the increase in terms of the pool of venture in general. Right. We said worldwide private equity has grown by 20 fold. You know venture capital over this period has grown closer to 100 fold in terms of its activity. And when you look at the mix of what it looked like in 2001, you essentially saw around 80 to 83% in the United States, another 10% in the developed developed rest of the world and a scattering in more developing places. But China essentially under 1% of the pool in terms of activity. I started going in the late 90s to China and you'd meet venture capitalists, but they weren't really venture capitalists, right? They were really people working at state owned enterprises who were doing sort of business development thing. They didn't really have a fund, they didn't really have carried interest. And it was sort of, you know, sort of pseudo venture which was there. And then what one saw is just this sort of amazing growth in terms of activity at a high points in the late 20 tens, you know, somewhere around 30% of all the venture dollars in the world were invested in China. And essentially this, you know, not just simply a lot more money, but also an enormous increase in terms of the sophistication of the groups that were there.

Right. That, you know, again, the sort of baseline was quite low. But we say one thing that China's been good at is learning things really quickly. And if you look at the sort of caliber of the groups that were that were raised in promulgated over this period, right. They just became enormously successful at at doing stuff and figuring out which of, you know, some of which was emulating us strategies and saying, let's take model business models that have worked in the United States and carry it over, but particularly over the course of the 20 tens, we saw a much more of an evolution of sort of China specific kind of business models. And we increasingly saw, you know, places like India and other places in the emerging economies looking not to Silicon Valley, but looking to companies in China as the sort of models and the templates for which they were to to follow. Right. So really the sort of extraordinary, extraordinary, extraordinary growth, clearly with the benefit of hindsight, if I'd known what was going to happen, I would have just turned in my resignation at Harvard and gone to Shenhua and taught there and be really rich now. But what can you say? We all make a few mistakes in life, so, you know. Not only was this a lot of growth, but it was also very successful in terms of doing it right.

Did you say what is it that makes, you know, these kind of early stage investing work? It tends to be the unicorns, the mega unicorns, the DC coins and so forth. Right. And we sort of go down the list of the, you know, the sort of great companies that were created, you know, many of which were in this, you know, e-commerce kind of e-commerce space, but also sort of more broadly, certainly a huge amount in fintech and many other areas. And there was really sort of extraordinary returns, right? So if we sort of took a stopwatch and stopped at any time during the late 19, late 20 tens, China would be the winner and not even by close. Right. So this is essentially looking at two ways in terms of looking at returns. One, the internal rate of return. So just simply, you know, what is the sort of reinvested profits? The other is the, you know, the kind of metric that we often like to use the public market equivalents or the sort of ratio of the private returns to the comparable public returns. And we see that really sort of across the board. At that period of time, China was really the winner in terms of deploying, deploying these private private market funds. And clearly this is an area which a lot of very sophisticated investors, whether we think about university endowments here, family offices and others, made a lot of money doing this from having been early into the early into the early into the Chinese market.

You know, when. The Yale Endowment decided in 2002 that they were going to go ahead and do investing in China. David Swensen, who ran the endowment at the time, said I don't expect to make any money from my Chinese investments for 20 years, but ultimately for the for the for the next eight decades of the of the 21st century, I'm going to make a lot of money. Now, as it turns out, Yale made huge profits from their Chinese investments, you know, really throughout from almost, you know, within a few years of starting their investment program, The market the market evolved much more quickly than they had ever than they they had anticipated. So this, of course, you know, sort of and of course, this was on the back of a lot of economic growth. Right? So it wasn't just simply, you know, the emergence of the Internet and stuff. Right? But it was a period where a lot of growth and it's probably fair to say that it was also a period of some really smart regulatory decisions that, you know, did a lot to both make it easier to sort of set up funds in a way that sort of had this sort of hybrid kind of structure where they were able to sort of combine dollar and R&B investments to have a kind of flexibility, you know, doing a lot of stuff to try to create public markets, which would be on the one hand, vibrant, but hopefully without some of the craziness that's, you know, associated with, you know, some of the excesses of excesses along these lines.

So that's the good news. Right. And the sort of natural question then is to say what happened, what happened in the 2020s and how do we explain it? And perhaps more importantly, what do we think about going forward as as as an area for investment? Right. And, you know, I think that it's obviously a complicated question without, you know, a super easy answer. But let's try to look at the data that's there. And then I'll end by suggesting a few hypotheses, not really having the answer, but at least a few ideas. Right? So what's happened? We know what's happened. There's just been a lot less activity in terms of what's in terms of investment, investment area, right? So we've certainly seen a drop in deals done, you know, fund raising, particularly dramatic, which we might regard as, you know, sort of a future indicator here in terms of what people think about what's going to happen going going forward. Right. I mean, venture returns in general around the world haven't been fabulous in the recent years. But, you know, certainly on a relative basis, China has gone from being an outperformer to being an underperformer in terms of in terms of the the returns that have been enjoyed.

And of course, a lot of that has had to do with the exit markets, right? That when we think about venture investing or private market investing in general, the way that you generally do well is by selling the stuff at an attractive price to someone else. And, you know, perhaps the decline, the decline of the public markets in IPO markets worldwide was not a great event for, you know, early stage investors or growth investors anywhere. But, you know, the the Chinese industry was characterized even relative to the US by a very high, you know, a very high, very low DPI is what often we call it in the private land, the sort of ratio of distributed money to, to, to paid in. So in other words, if you look at the funds, you saw a lot of funds saying they were 2.5 x or three x, but when you looked at actually how much money they had returned to the investors, in many cases it was only 0.1 or 0 point 10 or 20% of the amount that had been raised. So essentially, if one's in a situation where you've actually returned the money to your investors and then the market goes down, you know, the investors may or may not have sold the stock, but at least in terms of your score, you're doing pretty well.

You know, for many of the Chinese venture funds, in particular in early stage investors in general, because so much of the stuff was still the value that had been created, was still in stock, that they were holding that sort of lock up, that that sort of seizing up of a public markets was an extremely negative, extremely negative event for them. And this is clearly reflected itself in, in in in in in sentiment as well. These are essentially foreign investors in China. And the dark, dark blue is the ones who think that things are getting better. The answer seems to be less of them before. And the light green is the ones saying that from an investment environment, things are sort of getting getting worse. And we clearly can see it in terms of the dry up, in terms of capital flowing, flowing, flowing in. So this has ended up having a bunch of implications. Clearly, one of them is essentially the the the really the decline in terms of cross border, cross border kind of activities. Right. That in many senses, we had a workshop right before the beginning of Covid at Xinhua where we had a bunch of venture capitalists and investors, both from the United States and China there. And even at that point, there was a sense of saying a lot of the magic in terms of the industry in China has been that cross fertilization between the US and China.

Right? Either the ideas, you know, business models coming over from the US capital flowing both ways, you know, the sort of ability of things to, you know, evolve and mutate in a variety of different ways. There was sort of been that for much of the 2020 tens, there was really this sort of very healthy cross fertilization of ideas that led to a lot of the creativity in the Chinese venture industry. And even in the end of 2019, it was clear that that kind of interchange was endangered. And if we think about what's happened in the years since, it's become much more dramatically So, you know, probably the most, most clearest illustration of this was Sequoia's decoupling, where essentially they said we're not really able to still have the, you know, the US, China and India all sitting under the same, all sitting under the same same roof, you know, probably a lot of which was a reflection of some of the pressures that the organizations, organizations came came came, came under and certainly within. Within Asia, we're seeing a shift of not certainly all investors, but certainly many global investors to focusing on other places within within, within, within Asia. Right. And with a sense of saying, you know, probably with certainly a lot of the interest being absorbed by by by by India, but also sort of looking across, you know, looking across South Asia for opportunities that I think I was talking to one of the endowments recently and they were like, we need that Asian magic in our portfolio, right? We need that kind of growth, economic growth and activity because, you know, let's face it, we're us is an old country with old men running around everywhere.

And we need dynamic, dynamic young people. But they, like many others, you know, sort of had these concerns around China. So they were sort of looking to many of these other places. The other thing, which was quite, quite striking is, of course, just simply how much of the Chinese investment capital itself is moving to moving to South Asia as well. You know, the number that was quoted while I was at the in in Singapore was that they've tabulated something like 500 distinct Chinese family offices that have set up offices in China in the last 18 months, in Singapore in the last 18 months. And it seems clear that it's not just simply the family families themselves getting wealth out, but, you know, many of the venture groups sort of feeling frustrated about their growth, equity groups feeling frustrated about their abilities to deploy money in China, looking to these looking to these regions as as as as well. Now, again, you might say part of this is probably just a mirroring of economic conditions more generally, right? When we think about growth, investing or venture investing in some sense, you know, we might characterize these as sort of high beta activities, right? When the economy does right, you say, what were the sort of great years for venture investing in the States in our lifetime? It was really years like 1999 and two.

1998 and 99. Late 90s, you know, early 2020s. Right. When the economy in both cases was sort of booming through a combination of circumstances. And if you're in a world where there is this sort of dramatic or a country where there's this dramatic slowdown, one is at least in the short run, going to have these kinds of issues and issues and issues and problems. But of course, there's a lot more to it. And certainly one of the the major issues has been the, you know, the the the geopolitical concerns in addition to sort of whatever the whatever the, you know, the formal formal limitations that governments like us and UK have put into place. There's also just the anxiety of sort of not knowing what the future brings. Right. And when you think about private market investing, you are committing money for a decade or longer, right? And you want to be sure that you can check into the hotel, but also that you can check out of the hotel later, later, later, later, later on. I think the other side of it, which is perhaps, you know.

Giving pause even for those Chinese investors who are raising money exclusively internally and as such aren't really subject to the geopolitical pressures of what the what the Biden administration might be doing and so forth, has been the seemingly increased willingness of the government to step into the stepped into the market and either provide encouragement for going into certain areas or else perhaps more to the point, discouragement for for for for other areas. Right. And, you know, certainly, you know, one of my old students I was talking to, you know, had basically made a lot of money doing investing in the EdTech and education space and social media, both of which have been very good up until the early 2020s, when the government sort of clamped down on both those areas in particular, made it very difficult to exit investments. And as you can imagine, sitting with a bunch of companies in your portfolio and being unable to sell them is not without it's not without, it's not without it's sort of not without its challenges. And certainly the one thing that is clear is that we are certainly seeing sort of changing of the guard, where one is seeing more government funds going into going into Chinese. Venture and private market investments, whether it's from state owned enterprises or, you know, provincial city governments and the like, instead of from the sort of traditional outside investors.

It's fair to say that that's not universal, that we know that, you know, the you know, many of the groups are targeting the the the the Gulf for for funding as well. But I think it's fair to say that, you know, it's just very competitive raising, raising, raising, raising, raising money. And that outside of the government it's become increasingly, increasingly, increasingly challenging. Again, it's hard to know how to think about these patterns. But certainly as we've seen, this sort of very substantial influx of public money into these funds, it does seem that the relative performance of the Chinese funds have dropped. It's hard to interpret that, but certainly it does sort of raise, raise, raise a set of questions. I. As I mentioned, I'm very enthusiastic about academic research, but I think in the interest of time, I'm going to sort of skip over a few of these things and sort of get to what I think are really the the most important question, which is really what do we see going going forward and in particular in the world that we are today, given the seeming challenges that are there, Is this really how do we think about it? Right. Certainly you can argue that in many cases the categories of investment where everyone has given up on an asset class often turn out with the benefit of hindsight to be exactly the times to invest there. Right. And we can think about many examples of families or other visionaries who did investments that were sort of completely counterintuitive that ended up generating huge returns or is this really more some sort of permanent, permanent, permanent change? That is that is here? I think it's fair to say that there's a lot we don't know and that I think certainly this is an this is an arena where, you know. Us as economists can say something. But a lot of what will need to be said is by political scientists, right. That certainly in venture and private markets in general, really around the world, the government plays an important role. But in China in particular, that has been the that has been the been the case. But I think we can sort of credibly lay out at least a couple of ideas in terms of how we might anticipate things moving moving forward. I think that certainly. One notion that you can imagine is that we've sort of gone through a recalibration, right? That we sort of saw a very small Chinese venture venture and private equity industry that became a very large industry. And then we saw this sort of process of of shrinkage where it sort of fell roughly from half of the heights that it originally was. And then this is essentially a process of discovering where the right level is. And that in some sense, private markets around the world are characterized by a lot of overshooting. Right. That you often don't know what the right thing is. And people are too skeptical and then they're too enthusiastic and they all rush in and then sort of they pull back and it's painful, but they sort of find the the sort of right level that's that that's that's there. And then in some sense, we might say that's probably or you might say in some sense may be the most likely kind of scenario that we won't see that China, instead of being this sort of super high returns that we saw during the 20 tens, will look like much more like an average market, like a Europe, let's say, with reasonable returns, with reasonable growth, you know, less, but certainly a shadow, not really at the same size with the same hype that it was during the 20 tens. And in some sense, in that case, you might say, well, you know, the public policy has a valuable role to play in terms of saying, let's, you know, in this sort of trough that we're in now, where you have all this fear and flight, that the public money can sort of shore up the industry and make sure that it sort of survives this period until it reaches its still it reaches its steady state. A more pessimistic view. Would be that. This kind of. Stuff, whether we're talking about venture or growth and so forth, is a function of things really coming together, which is really hard to create.

But once you lose it, it's it's it's very hard to sort of get it back in the bottle again. And we certainly know that around the world, a lot of governments have tried to go through efforts of creating entrepreneurial cultures and entrepreneurial networks. You know, in a few cases, it's worked fabulously well. And I think we can look at the experience in Israel or Singapore as examples where, you know, policies did a great job in terms of creating these complexes. But certainly in many places. And we can certainly look around Europe as an example. Governments have spent a lot of money trying to create these things with relatively little to show for it at the end of. At the end of the day, that it's just it's not easy to do. And there's sort of a tendency for people to want to go and do activity where everyone else is doing it. So you get these sort of big magnets like Silicon Valley, which sort of attract talent from talent from around the around the globe. And if you take that kind of view of it, you might say more pessimistically. You know, China had it for a while. They lost it. And it's going to be very hard. And I think this quote from Tony, Tony, who started making this point, it's going to be very hard to somehow get it back. Right. That that process of confidence and belief in it is something that's sort of very, very, very challenging. I think the third view, which would be the more optimistic one. Would be to say. You know, policy in China has been one of a lot of iteration and experimentation. Right. And we've certainly seen, you know, many instances of swings from one one side to the other. But I think if you were to characterize, you know, policies by and large in China over the last four decades, you'd say it's been pretty smart, right, that they have. It's not that mistakes haven't been made, you know, in some cases fairly spectacular mistakes, but there's been a sort of self-correcting mechanism where the. The sort of things that have ended up having reactions that had adverse things. There's been an ability to sort of course correct and to and to adjust as well. And if we feel that a lot of the difficulties that the that the venture sector has faced over the course of the last few years has been from some, you know, obviously some things that were global, things that couldn't have been anticipated. But also in a spirit of candor, of some policy mistakes that were made, you might say this is this is this is a set of people who can figure that out. And to sort of figure out how to how to correct for some of these some of these some of these issues and in particular, if.

The exit markets can be fixed. And if they can sort of recreate the kind of dynamism that we saw in the chinext and more recently the sort of star exchanges, you know, it may be a way to sort of balance, balance the objectives and sort of get the process going again. So do I have an answer? No. I wish I did with. I can say don't invest in Terra Luna, but I don't know whether we can say. There is a very clear, very clear thing here, since there are a lot of different a lot of different balls in play. But hopefully, at least this is for, I think, investors everywhere around the world, given the importance both of private markets and the importance of Chinese economy, hopefully thinking through some of these frameworks and some of these issues is hopefully helpful, helpful thing to helpful thing to to do. All right. Is it easy? No other mistakes? Yes. But I think this is certainly something that is you know, that certainly is a set of questions that sort of too big to ignore and certainly well worth well worth thinking through. So I think with that, I'll bring my formal remarks to an end and obviously would be delighted if anyone has any questions. Thank you.

Speaker2: Thank you. Josh, I think we got time for a couple of questions. So does anyone, anyone in the audience want to venture a question to start us off? We got one over there. Perfect.

Speaker3: Uh, the real estate market in China is another private market that you didn't touch upon. And crackdown has been particularly severe there. And a lot of the Chinese local wealth is locked up in that, right? So do you have any particular thoughts on the evolution of those markets and the government owned companies that are involved there?

Josh Lerner: Yeah. So I think this is a great set of issues. Probably we can think about depressing things about real estate, particularly when it comes to the commercial side in a lot more places than China and really get us in a bad mood to listen to the Red Sox. So I'll be I'll be really, really quick in that regard. I do think that clearly this is a serious issue just because, as you say, for so many, you know, sort of Chinese, this has been not just simply, you know, one investment, but really the investment for much of their much of their much of their savings. And I think it's fair to say that. Have there been have there been cycles of real estate overbuilding and speculation before? Yes. But in the earlier ones, they were really able to grow their way out of these of the overcapacity that was there, just simply because there was such robust, you know, inherent if you even if you're ridiculously overbuilt, if you're growing at ten, 12% a year, that's going to solve that's going to solve a lot of that's going to solve a lot of problems. So ultimately, I think the the answer to that question really comes down to is the is that kind of growth rate in China going to be capable of being reignited again to a level that would help them sort of grow out of that overcapacity problem in terms of real estate? But it's a great set of issues.

Speaker2: It's just I've got a question here. So let's assume China doesn't go back to what it was in terms of the opportunity. Where's the next place going to be? Is it is it India is the question?

Josh Lerner: Yeah, I mean, it's. I mean, India in some sense, you know, clearly is benefiting from really two phenomena, Right? One of which is just simply the fact that it's a country with. A lot of young people with a lot of technological talent. In a world where people want to save costs and outsource and so forth. We went earlier this year to Hyderabad, right? And you go through that tech city and Hyderabad. Right. And you know, it's just every American financial and software company seems to be constructing a huge facility there. And, you know, clearly that's one real benefit from it. The other side, of course, is just simply that, you know, China's loss really has been India's gain. Right. You say why is Microsoft doubling its research facility there? Well, part of it is that they're just simply expanding software research and they need more people to do it. But partially as they're shifting a bunch of people from their Chinese facility to Hyderabad. Right. So in a way, they they really are in a place where they're sort of having a double benefit, which is really accelerating the growth in a lot of ways.

Speaker2: So India could be the next big place.

Josh Lerner: And it seems like it is the, you know, the sort. I mean, that certainly from an investment perspective. You know, I think one of the things you that I've come to appreciate is just, you know, really the benefits of size. Right? And in a way, you say, why is it venture has been so successful, for instance, in the US and US and China? There are many reasons, but certainly a lot of it has to do with the fact that it's just a big integrated market. Now, maybe India is not quite as integrated in some respects, but it has that sort of benefit of size in a way that really plays to its favor as opposed to as investors saying, I'm going to go do something in Malaysia and in Indonesia and in Vietnam, where you've got quite distinct markets and it's perhaps a little bit more challenging to to to play that game.

Speaker2: Perfect. Josh, we're out of time. People want lunch, but that was brilliant. Thank you very much so much. Thank you.