STATE CASH a hole burns in the pocket of the secretary of the Shenzhen Communist Party. Wang Weizhong told angel investors late last year that if they set up a fund in southern China’s tech hub, the government would bear 40% of their losses. For the monstrous 400 billion yuan ($ 62 billion) public fund that supports such activity, an investment of 3 million yuan – the size of a typical angel investment – is rounding error. For private investors, the invitation sounds too good to be true. It could be.

After several years of accommodating monetary conditions and exceptional transactions, the liquidity of private equity (PE) in China began to dry up in 2018. New regulations made it more difficult for banks and insurers to invest. So-called “government-guided” funds set up by local governments or national ministries, by contrast, have flourished. Local authorities have been encouraged to launch such investment vehicles to attract startups to their cities, as well as talent, technology and possibly tax revenue. Due to a lack of in-house investment talent, most of them acted as sponsors (LPs) in private sector funds.

More than 1,000 government-guided funds have sprung up across China since 2015. At the end of 2020, they were managing some 9.4 billion yuan, according to China Venture, a research firm. A national fund focused on upgrading manufacturing technology held 147 billion yuan at last count. One microchip specialist exceeded 200 billion yuan in 2019. Almost all major cities in China operate their own funds. A Shenzhen municipal fund claims to have more than 400 billion yuan in assets under management, making it the largest such manager at the city level. In the city of Tianjin, in the north of the country, the Haihe River Industry Fund contributes 100 billion yuan as well as 400 billion yuan from other investors.

Therefore, PE in China is now full of public funding. In 2015, private sector money accounted for at least 70% of sponsorship funds flowing into the industry. At the end of 2019, state-backed funds were at least that much. Their dominance has only increased since then; according to some figures, they hold over 90% of the money in Chinese funds of funds (i.e. those that invest in other funds). According to Chinese media, learning to manage public funds is now a “compulsory course” for PE managers.

Some state influence is now inevitable. But whether this is beneficial or not is hotly contested. Some investors and advisers argue that taking government cash can help align private and public interests. “Government LPs can open doors for you, ”says Kiki Yang of Bain, a consulting firm. Public fund managers often understand local policy goals and can point investors in the right direction, says a venture capitalist. The influence can go too far, however: Shenzhen Capital, a huge state-owned fund, posted photos on its website of a meeting it held in December, in which it helped each of the 42 companies. in which he had invested to start a Communist Party committee. These are seen as a way to imbue private businesses with party ideology.

There are also other drawbacks. Public funds “crowd out others LPs, ”says one of China’s leading venture capitalists. Clear mismatches in interests have also surfaced. The members of China PE the elite cut their teeth in global investment groups such as KKR and TPG, two American firms. Their main objective is to produce high yields for LPs. This is not the case for government-guided funds. “You rarely have a guided fund that seeks returns,” an advisor tells several of them. Instead, public investors are primarily trying to generate windfall in local tax revenues by attracting new businesses, especially tech groups. Balancing these interests can lead to tension, explains one China-based investor, and often results in investments that are dependent on whether or not a business is willing to relocate to a specific city. Some even fear that such problems will gradually reduce overall returns for private sector investors.

So far, however, the arrangement has worked well for many private funds. With the demise of smaller funds in recent years, either due to a lack of capital or huge losses, the competition for target assets has subsided somewhat. The market is healthier, investors say, as private and public capital is channeled to better fund managers.

But will it last? A lingering concern for some PE investors is that government funds could do without intermediaries and make more of their own direct investments. Several large government funds have recruited from private sector banks and law firms, boosting their ability to make deals, notes a lawyer who works with them. “They are starting to compete with us directly,” explains the venture capitalist. Private investors will appreciate government liquidity much less when they try to outbid. ■

This article appeared in the Finance and Economics section of the print edition under the headline “Serving a Higher Purpose”