2019 was a volatile year for the public markets, pulled down by the trade disputes between the US and China, and buoyed by a continued low to negative interest rate environment. While the S&P 500 ended at a record high in 2019, the volatility has forced a healthy focus on quality going into 2020, with investors more discerning about individual companies’ cash flow, unit economics, and long-term viability.
WeWork’s failed attempt at an initial public offering (“IPO”) is one example of this. The Softbank-backed coworking company publicly filed for an IPO on August 14, 2019. Prior to its IPO offering, WeWork underwent numerous funding rounds, including a series of debt financing rounds over the past two years. Before its listing application, it held more than US$22 billion of debt on its books, on a run-rate revenue of US$3.3 billion according to the company’s prospectus. This meant that the IPO application valued the company at more than 14x of its run-rate sales, despite making a loss of about US$900 million in the first half of 2019. The IPO paperwork further revealed corporate governance questions around Adam Neumann’s ownership of several buildings leased by WeWork in addition to millions of dollars’ worth of loans extended to him by the company. Within a matter of weeks, WeWork’s valuation fell to a fifth of their asking price, leading the company to shelve its IPO completely.
WeWork’s spectacular decline demonstrated that loss-making companies are not able to raise indefinite amounts of money without strong corporate governance and a clear path to profitability. We believe that WeWork’s setback has been positive for the market as a whole, as investors have become increasingly discerning toward the viability of companies’ business models and have taken steps toward a more grounded investment approach.
Since WeWork’s IPO, some investors have questioned how the sharp fall in its valuations will affect the state of venture capital in Asia and whether this will cause a trickle-down in the exit environment for Asian private equity investments. The short answer is that markets have continued to reward companies with good business models, strong growth and a path to profitability. Despite the valuation uncertainty driven by the WeWork IPO failure (from the IPO filing to the stepping down of CEO Adam Neumann shown as the blue shaded area in Exhibit 1), companies like the food delivery platform Meituan Dianping and online healthcare services platform Ping An Good Doctor have continued to perform well in the public markets, off the back of positive results.
Importantly, even though these companies are listed in Hong Kong, the protests that began in end-March have not dented their public market performance. Both companies have outperformed the Hang Seng Index, indicating that public market investors clearly separate the prospects of a company’s underlying business geography as opposed to its listing geography. Our view is that exit markets in Asia remain healthy, and that many investors and media sources may have overplayed the severity of the Hong Kong protests’ impact on the region’s financial markets. We believe that the actual economic impact of the Hong Kong protests is largely contained within the city of Hong Kong, as shown by the Hang Seng Index’s (“HSI”) sluggish performance due to its heavy exposure to local real estate and banking companies (Exhibit 1).
Exhibit 1: High quality companies invested in favorable secular trends still perform well despite being listed in Hong Kong
Source: Capital IQ, data as at Jan 6, 2020.
Indeed, the protests have not prevented high quality companies with good growth stories and business models from thriving despite being listed in Hong Kong, and neither has it dampened the region’s IPO environment. The HKEX booked the world’s largest IPO in 2019 to date in November (later outranked by the Saudi Aramco listing) with Alibaba’s secondary listing in Hong Kong. Alibaba’s consistent, high quality growth and healthy cash generation as shown in its 3Q 2019 results appealed to local investors who wanted to participate in Asia’s growth story. Alibaba’s strong performance is a good indicator of the resilient consumption growth trends in the Chinese economy (Exhibit 2).
Exhibit 2: Strong continued 3Q 2019 revenue and EBITDA growth by Alibaba
Source: Company filings.
As Asia’s economy continues to grow and local middle classes start to accumulate the excess savings to invest in financial assets, we expect Asia’s exchanges to become larger and provide more avenues for Asia-based businesses to exit.
Additionally, with the liberalization of the mainland’s rules on foreign stock ownership, a fund manager does not need to be physically present in Hong Kong or mainland China to get exposure to Hong Kong or mainland-listed equities. International funds like Fidelity can purchase stocks in Hong Kong and mainland China without restriction after Beijing scrapped the foreign investment limit for institutional investors in September this year, making the listing geography relatively less important. Already, according to Ernst and Young (“EY”), the Asia Pacific region led global IPO activity in 3Q 2019 . By volume, seven of the region’s exchanges made it to the top 10 exchanges globally, with 173 IPOs and US$23.7 billion in proceeds during the quarter.
Exhibit 3: Axiom’s capital is highly exposed to high-growth sectors driven by domestic consumption and secular trends
Axiom has focused principally on domestic demand driven themes since our inception, and its large exposure to high growth sectors and secular trends rooted in income growth, consumption upgrade and an increasing focus on health in Asia (Exhibit 3) has paid off. These are resilient trends driven by factors such as the incidence of diseases and rising wealth levels that are not linked to external shocks such as the US-China trade tensions. We are confident that this strategy will continue to allow us to reap the best returns Asia can offer.
1 “APAC Leads Global IPO Activity in Q3, SEA Rebounds: EY”, Deal Street Asia, Sep 25, 2019.
In November 2018, Chinese President Xi Jinping ordered the launch of the STAR Market, his pet project that is the Asian take of the NASDAQ exchange. The aim is to focus on sustaining economic growth in China by directing capital to technological innovation as opposed to the usual method of massive infrastructure spending. The exchange was successfully launched in mid-2019, with its first debut of 25 IPOs on July 22, 2019 (Exhibit 1), and we are delighted to share this in greater detail below.
Exhibit 1: First trading day of the STAR Market for its first 25 IPOs
July 22, 2019
Source: Google Images
The first of its kind, the STAR Market allows unprofitable technology companies, including pre-revenue biotechnology start-ups, to go public on the Shanghai Stock Exchange (“SSE”). However, China does not intend to compromise on the quality of listings on the STAR Market, with Chinese regulators adopting a new registration-based IPO mechanism for STAR Market. The new system requires full disclosure of earnings and operational information by listing applicants, and the SSE will assess these documents before approving their IPOs. Regulators are also adopting a market-based approach to determine the valuation of the companies through preliminary pricing inquiry to decide a price range, followed by book-building through bids submitted by offline investors.
The China Securities Regulatory Commission also reviews IPO documents to ensure companies’ ability to sustain their earnings growth post-IPO, and has a final say on the pricing of shares. Several IPO applications on the new exchange have since been turned down due to failure to comply with regulations or information disclosure requirements. We believe this is a huge step in the right direction to building a more sustainable and competitive listing avenue.
Exhibit 2: Progress of registrations on the STAR Market
No. of applications
Source: SSE, data downloaded on Oct 14, 2019
Companies from the first batch of 125 applications were predominantly from tech, healthcare and industrials, representing 43%, 22% and 20% in terms of application count (Exhibit 3).
Exhibit 3: Initial 125 STAR Market applicants are concentrated in tech and healthcare
By application count (GICS industry classification by colour)
The applicants tend to be faster growing in terms of revenue and earnings and had a higher R&D and capital expenditure CAGR than companies on the CSI300, an index which tracks the performance of the top 300 stocks in Shanghai and Shenzhen (Exhibit 4).
Exhibit 4: 2016-2018 fundamentals median CAGR of STAR Market applicants vs. CSI300
Source: FactSet, SSE
While companies in the pre-revenue and pre-earnings stage are eligible to go public on the STAR Market, most (98%) of the initial 125 applicants were already profit-making in their latest fiscal year and have been faring relatively well in terms of profit margins and ROEs (Exhibit 5 and 6) over the last 3 years. This outperformance of benchmarks in both respects by a decent 2% to 7% margin helps to alleviate investor concerns on investing in emerging companies, especially those which boast outstanding growth but lack in terms of profitability and monetization track record.
Exhibit 5: Profit margins (2016-2018)
Source: FactSet, SSE
Exhibit 6: Return on equity (2016-2018)
Source: FactSet, SSE
The first 25 companies that were listed on the first day of trading have performed phenomenally (Exhibit 7. For instance, Micro-Tech Nanjing, a newly listed medical equipment manufacturer and distributor, has gained c.154% in share price since its IPO as of September 30, 2019. Returns on IPO price from the first 25 listings ranged from the worst performing at 38% (Ningbo Ronbay New Energy) to the best performing at 250% (Beijing Worldia Diamond).
As of this writing, a total of 34 companies have been listed on the STAR Market and growing, making up a total market capitalization of RMB586B. Goldman Sachs estimates that the aggregate market capitalization of the STAR Market could reach US$2T in its mature stage and expects a steady pipeline of listing applications on the exchange. 
In May 2019, US President Donald Trump signed an executive order targeted at China’s Huawei Technologies to ban the use of telecommunications equipment from the company, the world’s largest manufacturer of 5G equipment.The STAR market provides a welcome alternative funding platform for Chinese start-ups amid the US-China trade war. It is also an attempt by China to reintroduce liquidity into the tech and healthcare sector to dissuade its valuable homegrown technology companies from listing overseas. This could also have an impact on Hong Kong-based listings of Chinese companies, as they look locally for capital instead.
Over the last decade, the increasing openness of Asia’s financial systems and the increased access that business owners have to liquidity, has enabled the region to become a more significant source of exits. This can be exemplified by China’s recent decision to remove the foreign investment cap and quotas for global funds to invest in Chinese equities and bonds.
Despite this, inability to exit investments remains a key concern that many investors face when contemplating investing in Asia. A report by Bain in early-2019 highlighted that due to the high multiples which private equity investors had paid to invest in Chinese tech companies that have earned poor returns, Bain had predicted an extremely difficult exit environment for those investments. However, these worries have eased in the subsequent months as China’s liquidity markets continued to adapt and evolve.
Overall, we expect capital markets for private equity exits in Asia to remain strong, with the financial markets constantly adapting to channel liquidity to companies with promising growth.
Exhibit 7: Cumulative return of the first 25 stocks listed on the STAR market since IPO
Share price returns as at Sep 30, 2019
 “Science-Technology Innovation Board (Part 2): What are China’s STARs?”, Goldman Sachs  “US Commerce Department places China’s Huawei and 70 affiliates on trade blacklist”, South China Morning Post  “Asia-Pacific Private Equity Report 2019”, Bain & Company
Over the last ten years, environmental, social and governance (ESG) factors have played an increasingly larger role in the investment analysis and decision-making processes for companies and private equity (PE) funds alike. Yet adoption of ESG investing in Asia has been slow, trailing far behind its Western counterparts. As shown in Exhibit 1, ESG investments as a percentage of total managed assets in 2016 was a mere 0.8% in Asia (ex-Japan) compared to 21.6% in the US and 52.6% in Europe . Australia/New Zealand while situated in the Asia Pacific region, was on par with Europe at 50.6%.
Exhibit 1: ESG Investing as percent of total managed assets by region, 2012-2016
Source: Global Sustainable Investment Alliance
Japan, with 3.4%, has emerged as a frontrunner for ESG in Asia given the launch of the Japanese Stewardship Code in 2014. The Code encourages sustainable investing practices and put the spotlight on ESG for some of the larger Japanese institutional investors. Many credited this reform for pushing Japan’s Government Pension Investment Fund (GPIF) to become a signatory of the United Nations-supported Principles for Responsible Investment (UNPRI), paving the way for other institutions in the region to follow suit.
While the number of fund managers who were signatories of the UNPRI grew from 1,200 in 2014 to over 2,000 in 2018, Asia still only makes up about 13% of the overall group. As evidenced by Exhibit 2 below, the number of investment managers who are UNPRI signatories in Asia as of 2018 is just over half of North America’s and only a quarter of Europe’s.
Exhibit 2: UNPRI signatories by region
Within the group of Asian investment managers (red bar), only a subset of 25% have an internally-managed private equity mandate. ESG is still considered a relatively new topic for many private equity managers in Asia.
A report from Bain & Company drives home this point:
55% of Asian LPs still do not have an ESG investing policy for private equity
60% of Asian PE funds do not require their portfolio companies to report on ESG issues or responsible investment
13% of Asian GPs say they have fully integrated ESG considerations at the investment committee level
Axiom and ESG
As one of Asia’s most local and experienced PE fund management firms, we are conscious that our investment management activities and business operations can have a positive impact on businesses, communities and the environment. As such, Axiom formalized our ESG policy on September 2017 and officially became a UNPRI Signatory in December 2017. As a signatory, Axiom commits to promoting the six UNPRI Principles (more information on the Principles can be found here: https://www.unpri.org/pri/what-are-the-principles-for-responsible-investment).
In 2019 we conducted ESG-related due diligence on our GPs in Axiom IV by evaluating their ESG policies and the degree of ESG integration within their investment decisions. GPs were then graded according to the chart in Exhibit 3.
Exhibit 3: ESG Grading Chart for GPs
We observed that 50% of our GPs had Advanced policies in ESG, 19% had Developing policies and 31% had no ESG policies at all (Exhibit 4). Moreover, we observed that our Growth and Buyout GPs tend to have more developed ESG policies compared to our VC GPs (Exhibit 5). VC GPs are generally ESG aware, but face difficulties in developing ESG policies due to the early stage nature of their portfolio companies.
For our GPs with no ESG program, Axiom encourages them to begin thinking about ESG and consider appointing a champion to drive ESG initiatives within their firm. If material ESG risks are identified during the on-going due diligence process, Axiom will require our GPs to commit to implementing appropriate measures to mitigate those risks.
Axiom recognizes that many challenges remain in the adoption of ESG considerations amongst fund managers in Asia. For many, there is still a lack of awareness about ESG and misconceptions surrounding its perceived effect on hindering financial performance. As more and more LP institutions in the region begin to incorporate ESG factors into their investment processes, this will no doubt have a trickle-down effect to the GPs and portfolio companies. Axiom commits to adopting best practices for ESG from our LPs and peers and further commits to helping educate our GPs to do the same.
 “Driving ESG Investing in Asia”, Oliver Wyman and AVPN, 2018.
 “Asia-Pacific Private Equity Report 2019”, Bain & Company
As we look around at the adoption of ESG practices in Asia, we can see that Asia is still lagging behind that of Europe or the US. Discover how Axiom, as one of Asia’s largest and most experienced private equity fund managers, strives to create a positive and long-lasting impact on the communities we belong to with our investment management activities and business operations.
Private equity investors have historically favored growth-stage investments in China as few true buyout opportunities existed. For entrepreneurs, an era of rapid economic growth meant that few were willing to sell controlling stakes in their businesses. For GPs, there seemed to be no shortage of fast-growing companies in need of expansion capital. But Hillhouse Capital’s latest US$10.6 billion fundraise—Asia’s biggest private equity capital raising to-date—has thrust China buyouts into the spotlight. As the market environment and private equity industry in China has evolved, we have observed the number and volume of buyout deals increase substantially over the last decade.
Exhibit 1: China’s share of the Asian buyout market has increased significantly
Source: Asian Venture Capital Journal (AVCJ).
As shown in Exhibit 1, Greater China buyouts (in purple) accounted for a mere 12% of total Asian buyouts from 2007-2011, doubling to 24% between 2012 and 2016. This follows the trajectory of a slowdown in GDP growth over the years. Between 2007 and 2011, China’s GDP growth rate was upwards of 12% per year; there was limited competition for private equity opportunities and public markets flourished. The period between 2012-2016 saw China’s GDP growth rate slow to below 10%. During this time, competition for deals increased and exit opportunities became more challenging as China closed its equity market to initial public offerings. Amid this market environment, opportunities for control investments rose dramatically.
A driver of increased buyout activity has been low interest rates where banks—both domestic and international—have been more aggressive at lending and facilitating large-cap leveraged buyout (LBO) deals. Typically, the leverage ratio of Asian LBO loans is 3.5-4x earnings but up until 2017, multiples as high as 5.8x were not uncommon.  According to Bloomberg, leverage on buyout loans across Asia has risen to levels last seen before the global financial crisis, with US$9.2 billion of financing in the pipeline – up 25% from the previous year.
However, last year witnessed a drop in the number and volume of buyout deals in China (Exhibit 2).
Exhibit 2: Buyout deals in China by number and deal value
Source: Asian Venture Capital Journal (AVCJ).
In our view, this is in part due to uncertainty over the US-China trade war as well as a deleveraging effort by the central government in an attempt to deal with concerns surrounding rising debt. We anticipate that the Chinese government’s pro-reform stance, easing monetary policy from the People’s Bank of China (PBoC) and fiscal stimulus in the form of tax cuts will mean that we likely won’t see a repeat of the 2018 lows moving forward.
Improved liquidity recently, as the government looks to slow its tightening, means that funding for such deals should be more readily available. In line with this, the China Banking and Insurance Regulatory Commission announced a major boost in bank lending, calling for domestic banks to double their lending to private-sector enterprises, ensuring that no less than 50% of financing goes to private businesses in the next three years.  As shown in Exhibit 3 below, Beijing’s loosening of controls has already started to take effect as evidenced by the spike in lending early this year.
Exhibit 3: Lending set to increase as controls loosen
Though cultural issues surrounding buyouts still exist, in recent years, challenging growth prospects and subdued exit markets, have led to a growing cultural acceptance for company owners to partner with a controlling sponsor. According to a survey done by Bain & Company, 50% of Asia-Pacific companies that were bought with a minority stake in the past two to three years had path-to-control provisions, up from 34% in their 2017 survey.
One such example of an entrepreneur selling out is Taiwan’s Ruentex Group, which sold most of its stake in Chinese hypermart operator Sun Art Retail to Alibaba (Ruentex retained a 4.67% stake post-transaction). The move allows Alibaba to increase its offline retail presence while providing Sun Art with the digital capabilities that are part and parcel of being a member of Alibaba’s ecosystem. While this particular transaction did not involve private equity money, we have seen a growing trend of similar corporate carve-outs in PE.
Multinationals are exiting their core and non-core divisions in China driven by the inability of these firms to compete with local players and drive growth via local customization. McDonald’s sold 80% of its Hong Kong and mainland China business to CITIC Capital and Carlyle, citing plans to ramp up restaurant openings and offer a “digital retail experience” to its customers. CITIC Capital alongside Baring Private Equity Asia also led the acquisition of Wall Street English from education group Pearson, in another corporate carve-out.
One trend we are witnessing in the buyout space is the surge in foreign acquisitions by Chinese firms. Chinese firms went on a spending spree in 2016, picking up overseas brands and valuable technology that would help China’s transition towards an economy driven by domestic consumption (See Exhibit 4).
Exhibit 4: Foreign acquisitions by Chinese firms hit an all-time high in 2016
Source: Asian Venture Capital Journal (AVCJ).
We have since noticed a slowdown in the pace of overseas acquisitions as Western governments have stepped in to reject some transactions particularly in the technology sector. For example, the US Committee for Foreign Investment in the United States (CFIUS) blocked the potential buyout of 80% of the LED business of Philips by Chinese buyout fund GO Scale Capital. China’s own government too has reined in deal making by implementing policies to curb what they deem as “irrational” outbound purchases in sectors such as entertainment and real estate.
In recent years we have observed that the number of growth and buyout funds raised in China has risen dramatically, doubling from 2016 to 2017 (see Exhibit 5). With this also comes a surge in the amount of capital raised in the Chinese market, which saw a peak in 2016. Although the amount of funds raised has since come down in the past two years, the underlying trend is clear. As the country’s private equity market evolves to resemble more mature buyout-heavy markets like the US and Europe, GPs are raising increasingly larger funds to meet the growing size of acquisitions. It is not uncommon today to see both established fund managers and emerging managers in China raising funds north of US$1.5 billion.
Exhibit 5: Amount of capital raised in China has surged
Source: Asian Venture Capital Journal (AVCJ).
This begs the question: Is there too much competition in the market for too few deals? In our view, the opportunity set in the Chinese market is robust enough to support the increase in the number of large funds. Not only has the number of target companies in China gone up, so has the size of these companies. As indicated in Exhibit 6, the median revenue of companies listed on the Shanghai Stock Exchange has increased by over 70% since 2009, requiring larger check sizes to consummate such deals.
Exhibit 6: Chinese companies are larger in size compared to before
Source: Capital IQ.
GPs who previously dominated the mid-market are naturally moving up the private equity food chain, leaving gaps for new managers to fill. At Axiom, we closely monitor the shifts in the landscape to identify the best segments within which to deploy capital.
JP Morgan, data for large-cap LBOs as of Aug 29, 2017
 “Leverage in Asia buyout loans is edging back to 2007 levels”, The Business Times, May 26, 2018.
 “China tells banks to double private-sector corporate loans”, Nikkei Asian Review, November 14, 2018.
Back in May, Harvard economist Carmen Reinhart painted a gloomy picture for Emerging Markets (EMs), claiming they are more vulnerable today than during the 2008 Global Financial Crisis (GFC).
She said, “The overall shape they’re in has a lot more cracks now than it did five years ago and certainly at the time of the global financial crisis. It’s both external and internal conditions. This is not gloom-and-doom, but there are a lot of internal and external vulnerabilities now that were not there during the taper tantrum.”
Ms. Reinhart’s comments came on the heels of an emerging market sell-off spurred by a stronger US dollar and massive devaluations in the Argentine peso and Turkish lira. It would be unfair, however, to paint all emerging markets with the same brush. Idiosyncrasies in one emerging market country due to geopolitical issues or poor balance of payments should not be extrapolated to all emerging markets as a whole. Indeed, the MSCI Emerging Markets Index alone counts 24 countries spanning Latin America, Europe, the Middle East, Africa and Asia, as its constituents.
We contend that the investor concerns stemming from the crisis in Latin America should have little relevance to the Asian markets. Asian economies are in a much stronger position today and are less vulnerable to contagion, than they were during the 1997 Asian Financial Crisis and the 2008 GFC.
Although Emerging Markets as a group displayed a sizeable current account surplus in 2008, it is now showing a small current account deficit. Emerging Asia fares slightly better with a slight current account surplus.
Exhibit 1: Current account balances as a % of GDP for emerging economies
Source: IMF, World Economic Database (Oct 2018).
If we drill down to Asian economies however, eight out of the eleven major economies in Asia ex-Japan enjoy current account surpluses. This is a reversal from the 1990s when Southeast Asia experienced rapid growth coupled with huge current account deficits, culminating in the outbreak of the Asian Financial Crisis in 1997. Today, the only Asian countries that have deficits are Indonesia, India and the Philippines.
Exhibit 2: Current account balances as a % of GDP for major Asia-ex Japan economies2
Source: IMF, World Economic Database (Oct 2018).
Strong positive current account balances are indicative of Asia’s excess savings and demonstrates its ability to meet its foreign exchange obligations.
One of Ms. Reinhart’s chief gripes is the mounting levels of debt that emerging markets have taken on, particularly in Sub-Saharan Africa and the Middle East – which have become increasingly indebted to China. While government debt to GDP in emerging markets has certainly increased from 34% in 2008 to 50% today, it is still less than half the level of debt in developed economies, whose ratios have gone from 78% in 2008 to 103% of GDP today.
We have also discussed and written about China’s debt at length in various thought pieces so we will not go into detail on that subject in this write-up. Suffice to say that the Chinese government has been actively deleveraging by instituting various initiatives for State-Owned Enterprise (SOE) reform and financial reform.
Exhibit 3: Chinese Central Government guidelines to strengthen asset and liability constraints on state-owned enterprises (SOEs)
Another reason for Ms. Reinhart’s pessimistic outlook on emerging markets is the notion that there is a growth slowdown. She points to Brazil, Chile and Turkey as countries that were doing well before but have been facing a growth slowdown in recent years, revealing vulnerabilities in their fiscal accounts.
This is not what we are seeing in Asia. The International Monetary Fund has estimated that Asia’s developing economies are poised to grow at 6.3% in 2019 compared to those in LatAm (2.6%), Middle East (2.7%) and Sub-Saharan Africa (3.8%).
Exhibit 4: IMF Growth Projections (%)
Source: IMF, World Economic Outlook (Oct 2018).
Asia looks to be the most dynamic region by a wide margin and is expected to account for a substantial share of global growth. This points to the fundamentals in Asia being better than other regions, providing a buffer against rising interest rates in the US and ongoing trade war disputes. The income growth of China and India are driven mainly by human capital, whereas their BRIC counterparts, Russia and Brazil, were more commodity-driven. The former is more sustainable and makes China and India better places for investment over the long term.
Exhibit 5: Income growth comparison between the BRICs
1 Base year is determined as a decade after economic reforms. China’s reforms began in 1978 when Deng Xiaoping opened up China’s economy. India’s reforms started in 1991.
Source: World Bank, World Development Indicators.
Asian economies have learnt their lessons from the Asian Financial Crisis and the sound monetary and fiscal policies since have ensured they have stood out from the EM malaise that has taken hold in other regions such as Latin America. In addition to this, the domestic consumer story is very much still in force throughout the region (home to around one third of the world’s population) and with the trend of rising incomes and higher life expectancy, this story is only set to continue growing.
Private equity in Asia is gaining traction in tandem. Accessing these hard-to-reach stories usually comes in the form of private capital funding young and hungry entrepreneurial startups. Given the lack of developed, and deep, capital markets in Asia, private equity is the perfect provider of much-needed capital to grow businesses and take them to the next level.
 “Harvard’s Reinhart says emerging markets are in tougher spot than during ’08 crisis”, Bloomberg, May 17, 2018.
 “Worse than 2008? Here’s what the emerging market numbers show”, Bloomberg, May 17, 2018.
 “A gentle rebuttal to Carmen Reinhart’, Ashmore Weekly Investor Research, May 29, 2018.
Chinese startup Pinduoduo made headlines this summer following a successful US debut on the NASDAQ, catapulting its founder Colin Huang to the position of China’s 12th richest person with a newly-minted fortune of US$13.8 billion.
Pinduoduo’s incredible rise
At just three-years old, Pinduoduo has seen explosive growth, quickly becoming the third-largest Chinese e-commerce app (by monthly active users) after Taobao and JD.com. Huang launched the company in 2015 as a social buying platform for fruits, dubbing it Pinhaohuo.
Exhibit 1: Pinduoduo is the third largest e-commerce app in China
Source: Jiguang data (jiguang.cn); WalktheChatAnalysis.
If a user wants to buy some watermelons on offer on the site, she would use WeChat to invite her network of friends to form a shopping team to get a lower price for their purchase. Once the number of purchasers hits a certain figure, the offer is unlocked and the goods are shipped to each buyer at a steep discount. Pinhaohuo’s C2B business model allows goods to be shipped directly from manufacturers to the end consumer. By eliminating layers upon layers of distributors, this lowers the price tag for end users while increasing the profit margins for suppliers – a win, win.
Exhibit 2: Tissue papers on sale
Later that year, Huang launched sister company Pinduoduo which ventured into verticals beyond fresh food. Pinduoduo now sells everything from kids’ toys to household goods. Like Pinhaohuo, the core function of the app is group buying. As shown in Exhibit 2, each product has a full price and a group-buy price. Users can either pick up 8 packs of tissue papers for RMB 16.9 (USD 2.5) or they can canvass enough friends and get the same deal for RMB 9.9 (USD 1.5). The highly addictive and viral nature of this model means companies can expend less on advertising, relying instead on word of mouth to generate sales.
Pinhaohuo and Pinduoduo ultimately merged in 2016 creating a group-buying juggernaut ready to take on China’s largest e-commerce players. In its IPO prospectus, Pinduoduo notes that it is one of the leading Chinese e-commerce players in terms of gross merchandise value (GMV) and number of total orders. Its GMV in 2017 and the twelve-month period ending June 30, 2018 was RMB141.2 billion and RMB262.1 billion (US$41.8 billion), respectively. During that same period, the number of total orders placed on its mobile platform reached 4.3 billion and 7.5 billion, respectively.
Who is the typical Pinduoduo customer?
As China morphs into a high-income society, the greatest growth will not come from its most affluent cities such as Beijing and Shanghai, but rather will be driven from the smaller and faster-growing Tier-3 and Tier-4 cities. This significant but often overlooked market is precisely the target market for Pinduoduo.
As Examples 3 and 4 highlight, 70% of Pinduoduo’s customers are female users with almost 65% of users living in Tier-3 cities or beyond. This is in contrast to JD.com where only 34.3% of its users are female and only half of its clientele reside in Tier-3 cities or beyond. Unsurprisingly, average orders on Pinduoduo are relatively low, as much as 10 times smaller than the average order on JD.com (Exhibit 5). This indicates that Pinduoduo’s customer base is predominantly lower-income females who are price-sensitive shoppers and are attracted to scoring bargain discounts on everyday household items.
Example 3: Female users dominate Pinduoduo’s customer base
Source: QuestMobile, 2018.3; WalktheChat Analysis
Exhibit 4: Distribution of Pinduoduo and JD users in various city tiers
Source: Jiguang data (jiguang.cn); WalktheChat Analysis
Exhibit 5: Average order value on JD.com, Taobao and Pinduoduo
Source: Company filings
Pinduoduo’s IPO and beyond
Pinduoduo successfully went public on the NASDAQ stock exchange on July 26, raising more than US$1.6 billion and putting the market valuation of the company at US$21 billion. This is particularly impressive given its two largest rivals JD.com and Alibaba were both operational for 16 years and 15 years respectively, before they listed on US stock exchanges. Pinduoduo achieved the same feat in three years.
Prior to its IPO, the company received funding from a slew of private equity funds including Gaorong II, Lightspeed II, Advantech I, Gaorong III, IDG China, Sequoia Capital, and Tencent Holdings, amongst others.
Pinduoduo’s rapid growth though, is not without its challenges. The company has come under scrutiny following accusations of counterfeit goods being sold under its platform. One example saw fake Pampers diapers which had packaging that resembled the original in color and branding, only to be sold under the name “Parmebos”.
However, this is an industry-wide problem in China that has plagued not just Pinduoduo but both e-commerce giants Alibaba and JD.com. Pinduoduo has taken steps to address the issue, pledging to enforce better mechanisms to tackle fake goods. The company issued an open letter on August 22nd stating that in the week spanning August 2nd to 9th, it had shut down 1,128 stores, taken down 4.3 million listings, and blocked 450,000 suspected listings from going up on its platform.
Counterfeit products aside, the allure of cheap goods and the high of scoring a good deal will likely continue to be a winning formula for Pinduoduo. Simple migration dynamics illustrate this point. China’s booming large cities are a well-known fact but what perhaps garners less coverage is that there are still 600 million Chinese people who live rurally. As the pace of urbanization continues, and they migrate to cities, the smaller Tier-3 and Tier-4 cities will be the ones that will benefit. This is exactly the type of consumer that Pinduoduo seeks to serve. With Tier-1 and Tier-2 cities becoming saturated (in terms of both people and costs for businesses), innovative and nimble companies that can adapt to serve the needs of numerous, but less high-profile cities, are set to reap the rewards. In this sense, Pinduoduo is already well on its way to grabbing the headlines that bigger rivals JD and Alibaba have been accustomed to.
 “Pinduoduo: A Close Look at the Fastest Growing App in China”, Walk The Chat, June 18, 2018.
 “Pinduoduo removes 4.3 million listings in crackdown on fake goods after stock takes a hammering”, South China Morning Post, August 23, 2018.
Despite the tariffs rhetoric being ratcheted up in recent weeks, we see limited impact on the long-term growth stories of portfolio companies.
Short timeline of events
March 9, 2018 – The US announces a global tax on steel imports at 25% and aluminum imports at 10%. As China accounts for almost 50% of the world’s steel production and is the world’s largest steel exporter, it calls the tariffs “a serious attack on the normal international trade order”.
Exhibit 1: China accounts for almost 50% of the world’s steel production
Source: World Steel Association.
April 2, 2018 – China retaliates by hitting the US with tariffs on US$3 billion worth of exports that include 128 products.
April 3-4, 2018 – The US proposes a 25% tax on $50 billion worth of Chinese exports. The Chinese government mirrors this proposal, announcing a 25% tariff on $50 billion worth of US products.
Late April – Early May 2018 – US and China hold talks and tariff plans are put on hold.
May 29, 2018 – The White House revives the 25% tariff threat on $50 billion worth of Chinese goods.
June 15, 2018 – President Trump confirms the plan to slap punitive tariffs on $34 billion worth of Chinese exports to the US that is to take effect on July 6th (the effective date of tariffs on the remaining US$16 billion will be announced at a later date). China’s Ministry of Commerce announced that “all the previous agreements reached through talks will become invalid” and hit back with its own retaliatory tariffs covering $34 billion in imports from the US.
June 19, 2018 – Trump directs US Trade Representative Robert Lighthizer to identify an additional US$200 billion worth of Chinese goods on which to impose tariffs should China go through with its reciprocal tariffs.
Exhibit 2: Timeline of US-China trade war
Source: Bloomberg, Press search
The issues at stake
1. The large bilateral trade imbalance
According to the US Census Bureau, last year the US ran a US$335 billion trade deficit in goods and services with China, comprising the bulk of its US$566 billion trade deficit overall. This was the largest deficit since 2008 and President Trump has since come under pressure to rectify the situation.
2. Technology, intellectual property and fair competition
Beijing’s “Made in China 2025” campaign, an ambitious scheme for the Chinese state to back strategically-important industries such as automation and AI, is at the center of the trade dispute. The Trump administration contends that programs such as “Made in China 2025” are China’s way of “seizing economic leadership in advanced technology” and its policies include “coerce[ing] American companies into transferring their technology and intellectual property to domestic Chinese enterprises.”
With the US mid-term elections coming up in November, Trump has intensified his stance on issues like immigration and trade policies. Being tough on China and getting a better “deal” for America is rhetoric that will play well before his electorate and improve voter support. However, this could very well backfire in rural states, a stronghold of the Republican base, as farmers of soybeans and other commodities will be hard hit by China’s counter-tariffs. It is not in the current Chinese DNA to kowtow to foreigners so President Trump might have to keep escalating to appear stronger, with unintended consequences.
The biggest loser
“It’s clear that China does have much more to lose”. Those are the words of Peter Navarro, a senior White House trade advisor. But how true is that statement? All sorts of estimates have been posited about the likely negative implications on the Chinese economy.
It seems that the immediate impact on Chinese growth will be muted. A 25% tariff on US$50 billion of Chinese exports is expected to shave off just 0.1% of GDP. For an economy the size of China’s that is growing at around 6.5% year-on-year, this is a negligible number. Of course, if China’s reciprocal tariffs trigger further escalation from the US, this number will increase significantly. Also adding to the uncertainty is what effect the tit-for-tat dialogue will have on investment and business confidence as buyers adopt a “wait and see” approach.
The integration of supply chains also means that the impact to China is going to be less than what the headline number suggests. Fortunately, or unfortunately, the pain will be spread out across many geographies, as the Non-China portion of value-add to final exports is (in some industries) significant, as shown in Exhibit 3. Ironically, US companies will also be impacted as 37% of US imports from China are intermediate inputs, which directly impact the competitiveness of US companies in global markets.
Exhibit 3: Value-added structure of U.S. imports from China, in billions of U.S. dollars, 2014
Source: Brookings Institute.
Many domestic industries rely on imported parts or intermediate inputs that have no readily available US substitute. As a result, companies have to make the decision to either absorb a lower profit margin or pass on the burden of cost to its consumers and face lowered demand for their goods. Exhibit 4 highlights the top US imports from China based on 2017 values that will be affected by the upcoming tariffs.
Exhibit 4: US imports from Chinese of tariff-targeted products
Source: Financial Times.
From an economic standpoint, the general consensus is that trade wars are always sub-optimal. Disrupting supply chains hurts not just China, but US companies as well as third countries that become collateral damage. A large share of Chinese exports come from foreign value-added. Based on the OECD’s Trade in Value Added database, Taiwan, Malaysia and South Korea are the countries that are expected to be hardest hit should Chinese exports take a dive . Interconnected supply chains also mean that negative sentiment will have a ripple effect throughout the global economy. We expect this impact to be worse on the public markets than on the real economy.
From a political and strategic standpoint, taking a hardline stance against China only serves to undermine America’s role as a trustworthy partner among other trading nations. We saw that after President Trump withdrew from the Trans Pacific Partnership (TPP) in 2017, the 11 remaining nations in the TPP forged ahead with a revised agreement which was signed in 2018. We expect new trade partnerships in the region to form if Trump’s policymaking leaves a vacuum which China is more than happy to fill. As we have seen time and time again, China is in a fiscal position to offer incentives to foster economic ties with its neighbors, furthering its role as an attractive economic and geo-political partner.
China understands that while it must retaliate against any provocations from the US, it is in its best interests to pick its battles carefully and ensure that any fallout will not deter it from going down the path of reform and opening up. A senior Chinese government official was quoted in the South China Morning Post as saying, “The message from the top is that ‘nothing can stop China from opening up. It is particularly important for 2018 when China is celebrating the 40th anniversary of its ‘reform and opening up’ policy.” This kind of restraint shown by the Chinese would not be possible if Xi was not fully in charge and capable of pushing through tough policies via a streamlined top-down approach.
China’s “national will”
As we outlined in the Annual Meeting, China is one of the few countries that can exercise a “national will”. Policymakers in Beijing desperately want to avoid a repeat of the stock market turbulence of June 2015, and therefore are willing and able to adjust monetary policy to keep the economy stable. We are already seeing this happen in response to the latest trade spat.
On June 18, 2018, the People’s Bank of China (PBOC) lent 200 billion yuan to financial institutions using its medium-term lending (MLF) facility to ensure domestic demand holds up in the face of these trade headwinds. Just a week later the central bank reduced the reserve ratio requirement (RRR) of Chinese banks by 0.5% (effective July 5, 2018), unleashing a further 700 billion yuan of liquidity into the system. This will help banks boost credit supply to smaller companies.
Furthermore, as part of the reforms that were announced during the National People’s Congress in March, Chinese authorities have cut individual income taxes. While this was not in direct response to recent trade issues, this will be a welcome boost to domestic consumption. It is estimated that the tax cut could affect 80% of the 340 million urban registered workers and potentially boosting consumption by US$19 billion, equivalent to 0.15% GDP. These are just a few examples of how Chinese policymakers can take concrete steps to bolster demand and direct money to parts of the economy where it is needed.
Another potential lever at the disposal of the PBoC is managing the RMB’s daily “fix rate” to the greenback to make existing exports more competitive. The US$250 billion worth of exports on which the tariffs are proposed is equal to 2.2% of GDP. Unsurprisingly, the Chinese currency has consistently weakened over the past month (depreciating around 3% in June). This has already offset the actual impact of the tariffs and can be used to help ameliorate further tariff announcements.
Additionally, amid the media sensationalism, this US$50 billion number is mentioned as though the whole amount of exports will magically evaporate. This is not the case. The US no longer makes a sizeable chunk of certain goods, including electronics such as mobile phones.
Exhibit 5: Top 10 China exporting sectors to the US, 2017
Source: J.P. Morgan
As indicated in Exhibit 5, the bulk of China’s exports to the US is in the tech and machinery space. With an estimated US$72 billion worth of mobile phones being exported from China, even if tariffs go up, the vast majority of these shipments will still find their way into the US.
How does this affect private equity in Asia?
Although Trump has stated that he will not impose additional restrictions on Chinese investments, he could still restrict Chinese acquisitions in high-tech sectors and call for stricter controls for transfers of intellectual property. If China responds in kind, this could be even more of a hit to the US as US companies have an estimated US$260 billion of FDI invested in China, almost double the US$140 billion that Chinese companies have of FDI in the US .
As conditions between the US and China deteriorate, Chinese tech companies are looking elsewhere to source components. Their destination of choice? Israel. At least six Chinese tech companies have discussed investment opportunities with Israeli microchip makers since March. Chinese companies are also shoring up domestic supply chains to reduce their reliance on the US. Alibaba recently acquired microchip supplier Hangzhou C-SKY Microsystems, while Baidu and Huawei have both reportedly poured money into developing their own chips.
Exhibit 6: The majority of Axiom’s investments are in the Consumer, Healthcare and Tech sectors
As Exhibit 6 illustrates, Axiom’s managers have been astute in the last few years, investing in sectors that will benefit from a China that emphasizes greater self-reliance for key technological inputs, and focusing on the three sectors highlighted in blue. As these are less impacted by global trade, we feel that this is the most defensible play given today’s uncertain market.
Though the risk of a trade war is looking increasingly likely at this stage, there is a possibility that both the US and China choose to back down from further escalation. We have seen this play out twice before in 1994 and 1996 where tariffs and retaliatory tariffs were called off. The tariffs went into effect July 6, 2018 although both sides now have a three-week window for further negotiations. Even if the trade balance issue is resolved in the near-term, China’s rising dominance and what this means for US/China relations as a whole remains a looming issue.
We like to apply Deng Xiaoping’s wisdom to the current situation. He once opined that one should “hide brightness, nourish obscurity”. Essentially saying that in order to prosper, you should fly under the radar. In this vein, big, foreign, headline-grabbing deals are going to be attracting attention of policymakers in both the US and China. Axiom’s strategy has always focused on the fast-growing domestic sectors which are driven by non-trade or politically related factors such as the incidence of disease (healthcare), rising standards of living (consumption) and greater familiarity and propensity to utilize technology in our everyday lives (IT). We continue to focus on doing local deals and tapping into opportunities that others may not even be aware exist.
 “Notice of Determination and Request for Public Comment Concerning Proposed Determination of Action Pursuant to Section 301: China’s Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation”, Office of the United States Trade Representative, April 3, 2018.
 “China: At the edge of a trade war”, J.P. Morgan, June 18, 2018.
 “Why a trade war with China would hurt the U.S. and its allies, too”, Brookings Institute, April 4, 2018.
 “Global Insight: Trade War, Day 1 – Forecasting the Casualties”, Bloomberg Intelligence, June 18, 2018.
 “Trump may pull the trigger on tariffs but China will pick its battles, sources say,” South China Morning Post, July 5, 2018.
 “China eases policy to offset trade risk and liquidity concerns,” Citi Asia Strategy Bulletin, June 19, 2018.
 “U.S. –China trade tension,” J.P. Morgan, May 21, 2018.
On March 11, 2018, 3,000 delegates gathered in the Great Hall of the People in Beijing and voted to abolish the two-term limit on the Chinese presidency. The vote passed almost unanimously with only two dissenting votes. This announcement was met swiftly by predominantly negative reports in the Western media prompting claims of “Chairman Mao 2.0” and fears that China would be returning to the dangerous days of strongman rule. In our view, Xi’s crystallization of power actually lowers the medium-term risk in China. His firm grip on power actually brings stability to the Chinese leadership which we have not seen since 2002 when Jiang Zemin retired as Chinese President and Party Secretary of the Chinese Communist Party. In other words, if you were sold on investing in China before, you should be even more gung-ho on investing in China today.
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Renminbi (“RMB”) funds as an asset class has seen robust growth in the past ten years, spurred by stock market liberalization and the inﬂux of capital from state-backed funds and government guidance funds.
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