China's private equity boom, sparked by the prospect of quick and easy money and returns as high as 400 times on a cash investment, triggered a wave of fund launches, creating as many of them in China as the rest of the world combined.
That boom appears to have now come to an abrupt end.
Domestic market weakness, tight monetary policy and growing economic uncertainty are making both fundraisings and exits for private equity firms increasingly difficult.
As a result, many speculative funds which invest in companies just before an initial public offering only to sell out soon after their listings could be wiped out.
"China has about 3,500 private equity funds and that's an awful lot," said Gao Jianbin, Shanghai-based partner of PricewaterhouseCoopers.
"At the end of the day, only those with management expertise and the ability to grow invested companies can survive," he said, adding that many funds would be forced to focus on venture capital and mergers and acquisitions businesses.
Prior to the 2008 financial crisis, industry experts estimated the total size of the entire global industry to be around 3,000-4,000 funds. But the definition of a private equity fund in China compared to the rest of the world can be quite different.
Private equity deals normally involve a firm putting a small amount of cash down for a takeover, and borrowing the rest. After streamlining the company, the firm sells it at a premium and pockets the money, keeping part of the profit and handing the rest back to institutional investors.
In China, ownership restrictions are widespread and leverage finance markets are still in their infancy, so the vast majority of deals are done in cash and for a minority stake. In that sense, it's often hard to tell the difference between a private equity, venture capital, and hedge fund deal in China. Chinese funds generally lack the kind of institutional backing that their Western peers have.
China's private equity boom started immediately after the 2008 global financial crisis, spurred by a flurry of IPOs following the launch of the Nasdaq-style ChiNext board on the Shenzhen exchange, as well as the $586 billion economic stimulus package Beijing put in place to ward off financial contagion.
According to fund consultancy ChinaVenture, 1,084 yuan-denominated private equity and venture capital funds, including those of global buyout giants the Carlyle Group, Blackstone Group (BX.N) and TPG Capital TPG.UL, were launched in China over the past three years, raising a combined $68.7 billion.
That compares with 925 funds launched in the United States during the same period, raising $236 billion, according to Thomson Reuters data.
Unlike in mature markets, most Chinese fund managers, including venture capitalists, have up to now only focused on pre-IPO deals, betting on listings that would typically boost the value of their investments. Currently, 90 per cent of exits were made through IPOs.
In a glaring example of how lucrative such pre-IPO deals were, New Horizon Capital made a stellar unrealised investment return of 400 times from its investment in Sinovel Wind Group Co Ltd (601558.SS) after the wind power company went public in January, according to fund consultancy Zero2IPO Group.
Officials at New Horizon could not be reached for comment.
The prospect of a quick and profitable exit through IPOs has been dimmed by a domestic stock marketthat has tumbled nearly 20 per cent in the second half of 2011 and now rests near two-and-half-year lows.
Fundraising also has become difficult as local governments, which typically provide seed capital for new funds, are now struggling to manage more than 10 trillion yuan ($1.57 trillion)worth of debts that have accumulated over the past few years.
Private entrepreneurs -- another important investor base for Chinese private equity firms -- also are feeling squeezed by slowing business conditions and tightening credit.
The private equity sector in China has been very loosely regulated amid a power struggle between the securities regulator and the top economic planning agency which are both eyeing control over what was once a fast-growing sector.
As such there is no official data on the sector and latest available industry figures are outdated because they do not reflect the current fundraising environment. But fund managers say the sharp downturn in the sector has been evident.
"The climate has cooled drastically in the second half," said Zhang Zheng, managing director of China-focused private equity firm Jade Invest.
To survive, private equity managers will need to do more than just bet on IPOs to win investors, analysts say.
"Investors would require that fund managers have a profound understanding of the businesses they invest in," Vincent Huang, partner of global private equity fund-of-funds manager Pantheon, said at a recent financial conference in Shanghai.
"This is what made TPG, Bain and KKR global giants. But 90 per cent of Chinese fund managers are not equipped with that ability."
The looming shake-up is seen by many as a natural and necessary step in developing China's nascent private equity market, and not necessarily a death knell.
"There's so much wealth in China that this industry will not die out as many commentators predict, but it needs to be managed," said one senior executive of a Western private equity firm, who was not allowed to speak to the media and thus did not want to be identified.
"Some funds will grow, and it's premature to be bearish."