Chinese capital markets remain extremely volatile, and while 2016 has been off to a similar start for our businesses as last year, concerns about the reliability of official economic numbers in China, abilities of policymakers, transition to a consumer-led economy and strength of the rising middle class are prevalent. We still believe that China’s New Normal thesis remains intact, which will be driven by rising consumer spending, less fixed asset investment, and greater economic liberalizations. We are hopeful that countries in China’s stage of development, with current account surpluses, trillions in reserves and massive savings, do not have crises, they have reorganizations.

China’s reorganization comes at an interesting time for our funds. We have fully invested Lunar Capital Partners III and are entering harvest time in a challenging market. Lunar Capital Partners IV has begun to deploy capital in Project Castle, acquiring leading snack food brands. We remain confident in our consumer thesis, but mindful of the challenges, which we would highlight as follows:

China’s administration continues to undergo challenging political reform. President Xi’s campaign to rid government of corruption and moral decay has created tension that is playing out publicly, resulting in unclear decision-making and fuzzy signals from the top, which have presented challenges for private businesses. We remain of the view that operating in industries with minimal government intervention, such as food and apparel, and where success is much more a function of supply and demand, continues to be the safest course.

Looming credit concerns in China are affecting SOEs financed by state back lenders. Total debt to GDP was 164% in 2008, and has risen to more than 250% in 2015. Corporate debt, now at more than 165% of GDP, is much higher than compared to levels of other developing countries, and NPLs are at their highest levels in 11 years. Some economists believe that defaults could be as much as 19% of all loans, equating to as much as $1.4 trillion, or 13.5% of GDP, which is in stark contrast to the official figures of approximately 2% (CLSA).  Offsetting this risk, China’s household balance sheets remain very strong, with debt less than 40% of GDP versus the USA at 75%, and savings at 50% versus the USA at 20%.

Environmental and quality of life concerns are growing. Two-thirds of China’s energy is provided by coal; 80% of Chinese are exposed to pollution levels far exceeding those unsafe by US standards; Beijing’s air quality is comparable to 40 cigarettes per day, and pollution is linked to more than 4,000 deaths per day, or 17% of all deaths.  76% of people in China say air pollution is a big problem. This is all fueling the demand for a better quality of life. For some wealthy Chinese this means moving abroad and for the middle classes this is driving the demand for higher quality goods and lifestyle-related products and services.

PE in China is heavily concentrated in TMT. In 1995 there were approximately 10 private equity firms in China, 100 in 2000, 500 by 2005 and 8,000 by 2015. As much as 70% of these new managers are now managing RMB funds and are quickly deploying capital in an opportunistic manner with minimal investment experience and track record of adding value. These new managers are driving competition for assets in the technology and media space and, bluntly, hunting unicorns. It is a very crowded trade and Bain recently estimated that such funding rose 6-fold since last year.

You will note that we do not list among the challenges worries about the pace of retail sales, wage growth, urbanization or the rise of the middle class. This is because the data surrounding those metrics has remained largely positive and in line with expectations. This gives us comfort that China’s New Normal is a transition that is bumpy but on track, and we intend to keep investing accordingly.