A new day is dawning in China. The country’s staunch zero-covid policy has come to an end, travel restrictions have eased and a once-looming crisis among China’s biggest real estate developers appears to have been averted.
As promising as those developments might seem, managers in the region are having a hard time selling investors – particularly those in North America – on China’s post-pandemic comeback story.
“Over the last two years, there has been a very pronounced shift in sentiment towards China,” Alfredo Lobo, a Hong Kong-based partner at capital advisory firm Hodes Weill & Associates, tells PERE, noting a growing number of US and European investors now want little or no exposure to the country.
During the opening weeks of 2023, PERE spoke with 10 industry professionals around the globe, including managers, capital raisers and investor consultants. The consensus was that this growing bias against exposure to new investments in China has become a headwind for Asia-Pacific-focused managers seeking to raise capital from Western sources.
“We just don’t see appetite for China right now at all among our client base,” says Christy Fields, managing principal and head of real estate portfolio solutions at the US pension consultant Meketa.
Responses to this trend have varied. But many firms – both established managers trying to maintain relationships with Western investors and newcomers aiming to plant a flag in the region – have made significant accommodations to meet investor demands.
“What we’ve seen regional funds doing, in terms of raising capital from LPs outside of the region, is move to lower their target allocations to China,” Lobo says, noting that a common offering for Asia-Pacific funds today is a cap on Chinese investments between 10 and 15 percent, well below the long-running standard of 50 percent. “In many cases, they are actually offering carve-outs to investors so that they’re excluded from any allocation to China within the fund.”
Some managers, he added, are dropping fund-level allocations to China to zero, committing only via sidecar structures that investors would have to opt into.
Capital flows
Political tensions in this arena are nothing new
China and the US have been locked in a trade war since 2018, and relations between the nations were deteriorating long before tariffs were introduced. That did not stop Western capital flowing into the region as a whole and – whether directly or through a diversified pool of investments – into China, too.
Just last year, Asia-Pacific fundraising had its best year since 2018, with 42 funds closing on $29.4 billion, according to PERE data.
Within that total was LaSalle Investment Management’s latest pan-Asian opportunistic vehicle, Asia Opportunity Fund VI, which closed on $2.2 billion including co-investments. In October 2021, PERE reported the vehicle would have a target allocation for China between 20 and 30 percent of the fund.
While LaSalle wrapped up its fundraising before the market’s China aversion reached current levels, Claire Tang, the firm’s co-chief investment officer for Asia-Pacific and head of Greater China, says the bifurcation of investor sentiment toward the country has been developing for years.
To avoid being hindered by growing anti-China sentiment, Tang says the firm has leaned on its local operatives to make sure it stays in compliance with both regulatory and market changes in the country. She tells PERE that has meant ensuring LaSalle will be able to sell assets from the fund in a less competitive market.
“We’re a lot more targeted in terms of the strategies that we want to focus on,” she says. “As the domestic REIT market as well as core funds continue to develop, there’s no question that the potential exit for deals would now shift toward domestic. We want to make sure we can execute a domestic exit, which means building products that are more attractive to domestic buyers.”
China-specific fundraising has also been strong in recent years, rising year over year since 2019. It reached $10 billion last year, its second-highest mark since PERE began tracking the market in 2008.
Niklas Amundsson, a Hong Kong-based partner for the private placement firm Monument Group, attributes this surge of capital to the optimism many investors felt toward China during what they hoped would be the end of the covid-19 pandemic.
“Fundraising came back strongly in the second half of 2020 and the first half of 2021 on the basis of China being the first one into a problem, first one out of a problem,” Amundsson says. “We saw a lot of interest in China strategies. So, we had trade war, we had covid, but no issues [with fundraising].”
Amundsson says the heightened reticence to invest in China today is a response to perceptions of heavy-handed government actions of the past year and a half. This began with crackdowns on education, technology, gaming and foreign investment into for-sale housing, he says. It culminated with the swift lockdown of Shanghai in February 2022, a time when many Chinese nationals who worked for investors were home visiting family members for the first time in two years.
“That’s the straw that broke the camel’s back,” he says. “Global investment committees got very concerned that if they can’t get their team members out of China, how can they expect to get their capital out of China?”
Not all managers are willing to make such concessions. Some feel that caps on Chinese investments would hamstring business plans too greatly. Others say that offering all investors the ability to opt out of China, be it through committing to a separate sleeve or merely checking a box on a term sheet, would undermine the credibility of the main fund.
One fundraising executive for a US manager, who was granted anonymity to discuss his firm’s ongoing effort to launch a pan-Asian fund series, said he is loath to offer a blanket China opt-out unless forced to do so by investors.
“If we come out right away, up front and do a non-China sleeve, we’re sending the market a signal that we don’t have a belief in China or that we have some concerns, even though it’s a political issue more than an economic one,” he said.
“My advice to our firm is going to be to go out with a pan-Asian fund including China. If we see that we’re not getting any traction there or a lot of investors are saying, ‘I’ll do this fund if you didn’t have China,’ then we’ll adapt to the market and create a sleeve that allows people to opt out.”
“We just don’t see appetite for China right now at all among our client base”
Christy Fields
Meketa
There is little doubt that the rollback of zero covid will be a boon to China and its neighbors. Prospective investors are once again able to visit managers and tour properties. But the policy’s end will not erase its legacy, a testament to the swiftness with which the Chinese government can upend even the most conservative of business projections.
“The problem with China was not just zero covid; it’s the unpredictability of the regime itself,” a Hong Kong-based capital raiser tells PERE.
“Real estate is an asset class where people want stability, cashflows, non-correlation with other asset classes. They aren’t looking for super high returns like they are with equities, private equity or venture capital. They just want something stable.”
Stability was a recurring theme in PERE’s conversations with market participants, as were broader economic concerns, changes to monetary policy and, of course, geopolitical tensions between China and the West.
Managers are having to take all these factors into consideration as they face the difficult choice about how much to engage with the world’s second-largest economy in the wake of its reopening. Those that commit to new deployment in China risk cutting themselves off from a significant portion of the global capital market. Meanwhile, those that restrict their exposure to the country could miss out on generational buying opportunities.
Offering options
Carve-outs, sidecars, side letters and similar arrangements have long been part of a manager’s toolkit for securing commitments. But the practice has typically been reserved for special situations – such as an investor hoping to avoid overconcentration in a certain market – and is often subject to some type of negotiation.
In today’s pan-Asian fundraising market, Lobo says, ex-China offerings are not only widespread, but they have become standard offerings.
“It’s been topical, and it’s been a concern of many investors for various reasons, so GPs have decided to tackle it head-on,” he says. “You see this in main offerings. After the headline and differentiation points, the China carve-out or China limitation is front and center there.”
One firm that has drawn a lot of attention in the industry for its efforts to segregate select investor capital from China is Hong Kong-based Gaw Capital Partners.
In January, PERE reported the manager had created a co-investment vehicle to run alongside its latest flagship fund, Gateway Real Estate Fund VII, that would only invest outside of China.
Previously, Gaw made similar vehicles available to institutions – including at least one Korean state investor – wary of adding more exposure to their home market. Where the firm’s latest offer breaks from tradition is in allowing an investor to have its capital ringfenced from a different country.
Christina Gaw, managing principal and global head of capital markets at Gaw, says her firm has long offered sidecar vehicles to help investors meet their specific needs. She also says that Gateway Real Estate Fund VII has sidecars that will seek more exposure to Greater China.
“The problem with China was not just zero covid; it’s the unpredictability of the regime itself”
Hong Kong-based capital raiser
Gaw acknowledges that US interest in China is “less pronounced than the old days,” but she pushes back against the notion that Western investors are uniformly disinterested in China, noting that her firm’s latest fund has commitments from some midsized US pensions.
“It cannot be so generalized. But there is a trend happening, which is having less capital from the West – the US in particular, and Europe to a certain extent – coming to China at the moment,” she says.
“But there are also other large institutional players from the Middle East and Asia having continuous interest in China and looking for opportunities as China opens up.”
Andrew Moore, head of Asia-Pacific real estate for the London-based manager Schroders Capital, says managers in the region have a careful balance to strike. On the one hand, they have an obligation to investors not to deploy their capital into markets they want no exposure to. On the other hand, he says, managers must be alive to market realities, one of which is that China is too critical to the region to remove it from pan-Asian strategies entirely.
“China is the world’s second-largest economy and the largest in APAC, so it is hard to ignore completely from a fund allocation perspective,” Moore says.
“In the light of current cautious investor sentiment, it may be best to propose strategies focused on very specific areas of the Chinese market.”
Schroders entered the Asia-Pacific region in 2020 by purchasing Hong Kong-based manager Pamfleet. Its holdings in the region include assets in Hong Kong, Shanghai, Singapore and Tokyo.
Moore declines to delve into the specific impact of China hesitancy on Schroders’ ongoing fundraising efforts in the region. But he says the firm has had success in quelling concerns by highlighting the potential upsides of investing in the country and zeroing in on the growth trends in the property types the fund will target.
“We ask investors to consider China for its diversification and growth potential,” he says. “We remind them that challenges present opportunities, and we tell them about specific areas of the Chinese market where we currently see entry opportunities with good long-term prospects, especially real estate with operational value-add such as life sciences and residential for rent.”
Politics at play
From Christina Gaw’s perspective, macroeconomic uncertainties often result in investors staying close to home. But she does not believe that has much to do with investors wanting their fund commitments carved out of China.
She and others see the current trend in Asia-Pacific fund formation as an extension of geopolitics. As tensions between the US and China continue to build, investors in both countries are following the leads of their respective governments and facing inward, Gaw says.
“It’s not as simple as whether globally the real estate market is like this or that,” Gaw says. “The world is decoupling. It is not globalizing like it had been the last two decades. Right now, it is going into fragmentation.”
Indeed, some US pensions have been barred from investing in China by governmental mandate. Texas and Florida – the second and third most populous states in the US – both passed laws last year forcing their public pensions to divest from China. Smaller states, such as South Dakota, have followed suit and still more are looking to do the same.
“We ask investors to consider China for its diversification and growth potential”
Andrew Moore
Schroders Capital
A bill working its way through Indiana state legislature would force the Indiana Public Retirement System to fully divest from China within five years. Corrine Youngs, policy director and legislative counsel for the state’s attorney general, explained a rationale for the proposal which was firmly in line with current US government’s anti-China attitude toward the country, during a public meeting in January.
Such rhetoric is not uncommon within some political circles in the US, particularly among hawkish conservatives. Likewise, some liberal advocates have raised concerns about investments in China because of the country’s alleged human rights violations against ethnic minorities, such as the Uyghurs.
Yet, attempts by partisans to rope investment policies into their culture wars have largely been unsuccessful thus far. Most pension capital in the US faces no binding constraint around investing in China.
Moving forward
Investor sentiment toward China and the Asia-Pacific region has ebbed and flowed since the pandemic began. This current bout of aversion to China could give way to renewed enthusiasm for the country or a permanent course-change on what many see as a long-term schism between China and the West.
In the near term, some managers are willing to accommodate investor reticence by mandating limited exposure to China or emphasizing other markets such as Japan, Korea, Australia and even India.
Others are leaning into Chinese properties backed by both secular trends and government policies, such as logistics warehouses and life science research facilities. Even if Western interest in these strategies remains limited, investors in the Middle East and Asia are poised to fill in the game. There is even hope that Chinese institutions, which have been net sellers in international real estate markets in recent years, will replace retreating foreign investors.
“Looking ahead, demand for direct and indirect exposure to Chinese real estate from domestic investors, especially insurance companies, may now strengthen,” Moore says.
For now, as managers scramble to make sense of this new environment, investors from the US and Europe have an opportunity to extract concessions around China exposure. Managers that are not sufficiently differentiated in the country may not have enough leverage to say no.
Driving forces
Investors have several justifiable reasons to steer clear of the Chinese market
One factor eroding interest in China among US investors is the country’s performance, which has lagged other markets. The Asia-Pacific trade group ANREV’s index of Chinese real estate funds delivered a one-year return of -9.85 percent through the end of the third quarter of 2022, while ANREV’s All Funds Index returned 8.33 percent. China also lagged the rest of the region on a three- and five-year basis.
“The reality of executing an investment strategy in China is just incredibly complex,” says Meketa’s Christy Fields. “For most of our investors who are public pension plans, it’s challenging to be able to appropriately resource those kinds of efforts without being able to generate a risk premium that we might find appropriate for investing in China these days.”
One North American investor agrees that pricing risk in China is a current deterrent from doing new business in the country, particularly given the country’s growth prospects have reduced: “In the construction of a portfolio, when we were getting 12 to 14 percent returns in China, it was okay to take on some risk. But when you get 5 to 6 percent when the risk has dramatically increased, that has to be factorized. This is not a political position, but a betting position.”
However, noticeably absent from market participants’ stated concerns was the government crackdown on developer borrowing in 2020. The policy shift led to credit crises within many domestic builders, including Evergrande Group, the country’s second-largest developer. The firm was pushed to the brink of collapse in 2021, sparking fears about its potential destabilizing effects on China and the global economy.
The ordeal speaks to the fear of government intervention and the country’s China-first tendencies, but does not necessarily present additional risks to prospective fund investors. Evergrande and the other developers entangled in the crisis were all domestic firms, largely focused on for-sale apartments.
Amid the distress and the government crackdown on borrowing from banks, firms like Gaw see an opportunity to provide credit financing. Others, such as Schroders, see the trouble in the for-sale market creating an opening for rental strategies.
“We anticipate strong growth in demand over the long term for quality rented accommodation in Chinese cities as urbanization continues,” Schroders’ Moore says. “This suggests that there is a large potential market for multifamily rental apartments. Indeed, China could one day become APAC’s largest multifamily market, ahead of Japan.”
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