China

“Nobody knows anything about China. Especially me.”
— Mike’s Rule #1 on China

One often hears institutional investors spout the notion that China’s such a big market that one “can’t not be invested in the country.”

This fascination with the size of the market is an old chestnut. Westerners have literally been talking about it for hundreds of years. The country’s power as a buyer is not lost on its leaders — it has long been a source of leverage.

Another trope is the reflection upon how rapidly China grew within an allocator’s lifetime. “I remember visiting Beijing in [year] and people tootled along on bicycles; now you can’t breathe in the city for the smog.”

China’s development over the last two decades has been utterly astonishing.

But that is in the past. What does it tell you about the opportunity over the next 10-15 years?

A decade or so ago, I believed that private equity and venture capital investors could do well in the country. In my estimation, there were two principal drivers of the opportunity:

1. Scarcity of capital for private businesses. China’s financial system was underdeveloped and inefficient: a bank-dominated, command-credit system in which capital flowed predominantly to SOEs. Capital markets were nascent: corporate bonds constituted ~2% of the bond market and the stock exchanges had long served primarily as conduits for the “privatization” of SOEs.
2. Policymakers were encouraging private sector development. Notably, this included dramatic financial sector reforms, such as the addition of two new stock exchanges, and initiatives to develop a local institutional investor base. More generally, policymakers believed that private sector development would increase domestic aggregate demand, thereby reducing China’s reliance upon export-led growth and alleviating global imbalances.

Neither of those drivers really defines China today. The internal and external conditions have changed materially.

There may be new drivers. The “New Economy” is a hot theme.

But we’re talking about China — the Party runs the show. (It’s worth revisiting “China’s Private Sector” from our March newsletter).

Western investors should ask themselves:

• Has the Petri dish of market-economy experiments run its course?
• Is the next decade likely to be one in which the Party lets entrepreneurial activity thrive?
• And lets international investors share in the benefits of growth?

I have serious doubts.

Several months ago, the Wall Street Journal ran a story outlining just how keen China was to have MSCI add its A-Shares to the MSCI EM Index. I suppose one could view this as an earnest attempt by China to open up and liberalize its financial sector, bringing greater institutional flows to exchanges that have been prone to the whims of retail sentiment. However, it’s hard not to shake the suspicion that they’ve stumbled upon a surge of dumb money.

I don’t follow what Senator Marco Rubio says about much of anything, but I was tickled reading his recent letter to MSCI regarding their decision to include China’s A-Shares in the Index.

“We can no longer allow China’s authoritarian government to reap the rewards of American and international capital markets while Chinese companies avoid financial disclosure and basic transparency, and place U.S. investors and pensioners at risk,” he said.

Good on him, says I.

Depending on whom you ask, the United States is home to somewhere around $28 trillion in private pension / retirement assets. It’s the largest pool in the world. It certainly dwarfs China’s $200 billion in pension assets [OECD], and it’s nearly 10x larger than China’s FX reserves.

The United States, too, has power as a buyer.

I find Rubio’s move refreshing. It flies in the face of the defeatism that I read weekly in the FT, and the whingeing I hear amongst the foreign policy / Wall Street / Silicon Valley crowds.

Maybe it’s a function of the small, yet vigorous strain of Jacksonianism embedded in my DNA, but I have two fairly high-conviction views:

1. Donald Trump is right to push back on the CCP; and
2. The United States has less to lose in the trade war.

Double bonus: no deal is the best politics for Trump — probably boosts his odds of getting reelected — and the worst for the CCP. Trump is a noxious person, but he has a nose for sniffing out others’ vulnerabilities.

Upwards of two million people took to the streets in Hong Kong to protest a bill that would allow for extradition to the mainland (and much else besides, over the long term).

I think it’s important to pause and reflect on the courage of these people. They are effectively protesting against a surveillance state, and they have everything to lose. The contrast in courage between the people in the streets and Western elites is stark, indeed.

I wonder: will the groundswell of resistance to the diktat of Beijing inspire investors to think a bit more deeply about where they allocate their capital?

Probably not.

But! If such investors do exist, they may wish to look for countries where capital is scarce, and where policymakers are encouraging the development of a more vibrant private sector.

Alla prossima,
Mike

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Shameless Plug

The Economist recently published an article on the growth of private credit in emerging markets, clearly taking a cue from EMPEA’s report on the topic.

Yours truly is quoted in the piece, with the bold prediction that “fundraising volumes could easily double [from $9.4 billion] without flooding the market.”

My reasoning was based on three hypotheses:

1. I reflected on Portico’s thought exercise (Does EM PE Scale?), which right-sized EM PE at $16 billion in annual fundraising.
2. There’s probably as much demand for debt as equity amongst EM entrepreneurs.
3. The self-liquidating nature of most debt products alleviates a bit of exit risk, so LPs may be a bit more comfortable with it.

 What say you?

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SoftBank in São Paulo

SoftBank — the deus ex machina of liquidity — launched a $5 billion fund for tech investments in Latin America a few months ago.

It’s a lot of money, but (1) LatAm is a region where there’s a scarcity of capital; and (2) I’m generally bullish on the region’s startup landscape.

SoftBank recently inked some interesting deals in Brazil: Loggi, a logistics platform, and Credits, a fintech company that offers secured loans.

Just getting warmed up!

I’m looking forward to the rollout of SoftBank’s next regional fund. Maybe $1 billion for Africa?

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Grab Bag

• Cambridge Associates doubles down on overweight China call. 
  As a counterbalance to this newsletter’s opening screed, here’s part two of Cambridge Associates’ bull case, which focuses on how to implement an overweight China strategy.
• Megafunds. 
  The Wall Street Journal discusses megafunds, defined as those >$10B in size. They’re more correlated to stock markets than small-cap and mid-market funds. They’ve also delivered 10.2% over a 12.75 year timespan, according to Cambridge Associates, which basically matches the S&P 500. #IlliquidityPremium
• Coller Capital’s Summer Barometer.
  Only 39% of LPs are spending more time researching and building GP relationships than they were five years ago. Net annual returns aren’t as hot as they once were, but they’re “more consistent” at a lower level.
• Abraaj.
  The United States has expanded its indictment (WSJ, FT).
• World Investment Report.
  FDI flows are declining globally — mostly due to Europe — but they’re growing in Africa and Asia.

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From the Bookshelf

In 1780, no one was claiming any more that France was in decline; on the contrary it was said that there were no longer any barriers to its advancements. At that time the theory of continuous and indefinite improvement of man took root. Twenty years before, the future held no hope; now nothing was to be feared from it. Men’s imaginations, in taking advance possession of this approaching and unheard-of happiness, made them unaware of the blessings they already enjoyed and hurtled them towards new things.

— Alexis De Tocqueville, The Ancien Régime and the Revolution (Penguin: 2008)

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.