Investor pullback shows private equity funds' China struggle

China-focused private equity firms are struggling for new cash, hit by increased skepticism among U.S. pension funds and endowments about the growing political and market risks of Asia's largest economy.

In a sign of a potential pullback, Harvard University's endowment is considering tapering its investments in China, according to people familiar with the matter, who asked not to be named discussing private information. A pension fund for Pennsylvania state employees hasn't committed new cash to Chinese private equity funds in the past 12 months, while Florida's pension system has halted new investments in China as it assesses the risks.

Such reluctance meant that U.S. dollar-denominated funds that invest in China raised $1.4 billion in the first quarter, the lowest amount for the same period since 2018 and a third consecutive quarter of declines, according to research firm Preqin. The pullback is hitting even high-profile China names. Ex-Goldman Sachs Group Inc. rainmaker Fred Hu's fund is still $500 million to $1 billion shy of its maximum raise with time running short. Firms in previous years had little problem reaching the so-called hard cap.

China's investment landscape is in turmoil, with some top investors shunning the nation after President Xi Jinping unleashed a broad crackdown on the private sector, reining in technology giants such as Tencent Holdings and Alibaba Group Holding. The U.S. has also slapped sanctions on Chinese firms and delisted some companies from markets in New York. Now China's close relationship with Russia and continuing travel restrictions in mainland China and Hong Kong are adding to risks.

As Chinese stocks tank and public listings stall, exits by private equity firms have been subdued. Industry watchers say a shakeout is coming after years of breakneck growth.

The number of active China private equity managers in 2019-2021 reached about 1,200, up 25% from previous three-year period, according to Bain & Co. Newer and smaller funds without solid track records are now being hardest hit, and the sector is set for a consolidation if the caution continues, the people said.

Even established names are taking longer to pull in investors.

Mr. Hu's Primavera Capital Group was able to close on its $4 billion target, but now has just two months left to reach its hard cap of $4.5 billion to $5 billion, the people said. The firm has yet to decide if it will need an extension before its deadline expires end of May, they said.

Founded by Goldman Sachs Group alumni Frank Tang, FountainVest Partners, is also short of its hard cap target after starting fundraising in late 2020, the people said.

A spokesman at Primavera declined to comment. Text messages and emails to FountainVest's Tang weren't answered.

"It's clear, all that's going on around the world including the U.S.-China relation, has had an impact on the financial markets overall," Mr. Hu said in an interview in March. "We have really sophisticated, high quality, blue chip global investors" and that helps "cover the noise and uncertainty," he said.

A successful fundraising typically takes less than 18 months to exceed the hard cap — the maximum size that's stipulated in limited partnership agreements.

Thomas Derr, a spokesman for the $40 billion Pennsylvania State Employees' Retirement System, said it hasn't debated or taken a position with regard to reducing investments in China. It has about 2% of exposure to China.

Harvard declined to provide information about its share of investments in China.

Given the uncertainties in emerging markets, Florida's State Board of Administration has, for now, stopped funding new investment strategies in China as it continues to assess the attendant risks, according to Kent Perez, deputy executive director. The pension fund reported this at a public meeting in March, outlining action taken following the completion of a survey on its China holdings earlier in 2022, Mr. Perez said.

The fund had less than 3% of its $253 billion in assets as of January, which includes the Florida Retirement System, invested in China.

The Washington State Investment Board, which has 3.5% of its $156 billion invested in Chinese assets, is conducting a periodic analysis of risk, including China, as geopolitical issues are getting a high degree of attention. Staff will present findings later this month, said Chris Phillips, a spokesman. "Emerging markets are often a natural part of the risk report," Mr. Phillips said. "We spend a lot of time analyzing risk, but it rarely results in any short-term change in investment strategy."

The reduced overall allocations come after many U.S. pension funds are actually "tapped out" in terms of capital capacity for new managers, one of the people said.

Still, some endowments and family office funds might still want to overallocate to China, hunting for venture capital managers focused on health care due to their outsized returns, the people said.

Michigan State University isn't changing strategy when it comes to China, which accounts for about 2% of its $4 billion endowment. It invested $50 million in a China long-short hedge fund at the end of 2021.

"We're not looking to pull back anything," said Phil Zecher, chief investment officer. "We're always concerned about governance issues anywhere we invest, whether it's corporate governance in the U.S. or the countries that we have exposure to."

But alternative investors are shifting their preferences to other Asian markets — at least in the short term. A survey by Preqin showed half of the 350 respondents viewed Southeast Asia as the best opportunity within emerging markets at the end of last year, up from 37% a year earlier. The shift reflects some investors delaying planned capital commitments into China, the research firm said.

Many global investors in 2021 were focused on "re-ups" — allocating to the same manager in previous rounds, and focusing on those with geographical spread in Asia rather than country-specific mandate, the people said. Blackstone in January raised $6.4 billion in Asia, with almost 100% of the investors in its first fund taking part in the second pool of capital.

So-called exits, or when private equity firms cash in on their investments, dropped in the second half of last year to 30% of the volume in the first six months of 2021, according to Bain. Just 35% of Chinese investment managers were confident in the country's outlook, a sharply divergent view that may signal a fundamental change in China's performance in 2022, Bain said. That compares with more than 60% in Asia as a whole.