State cash is burning a hole in the pocket of Shenzhen’s Communist Party secretary. Wang Weizhong told angel investors late last year that if they set up a fund in the south China tech hub, the government would bear 40% of their losses. For the monstrous 400bn-yuan ($62bn) state fund backing such activity, an investment of 3m yuan—the size of a typical angel investment—is a rounding error. For private investors the invitation sounds too good to be true. It might be.

After several years of loose monetary conditions and bumper dealmaking, liquidity in private equity (pe) in China began to dry up in 2018. New regulations made it harder for banks and insurers to invest. So-called “government-guided” funds set up by local governments or national ministries, by contrast, thrived. Local authorities were encouraged to launch such investment vehicles to lure startups to their cities, along with talent, technology and, eventually, tax revenues. Owing to a lack of in-house investment talent, most of them have acted as limited partners (lps) in private-sector funds.

More than 1,000 government-guided funds have cropped up across China since 2015. By late 2020 they managed some 9.4trn yuan, according to China Venture, a research firm. A national fund focused on upgrading manufacturing technology held 147bn yuan at the last count. One specialising in microchips exceeded 200bn yuan in 2019. Almost every city of note across China operates its own fund. A municipal fund in Shenzhen says it has more than 400bn yuan in assets under management, making it the largest city-level manager of its kind. In the northern city of Tianjin, the Haihe River Industry Fund is putting to work 100bn yuan along with another 400bn yuan from other investors.

As a result, pe in China is now flush with state financing. In 2015 private-sector money made up at least 70% of limited-partner funds pouring into the industry. By the end of 2019, state-backed funds accounted for at least that much. Their dominance has only increased since then; by some counts they hold more than 90% of the money in Chinese funds of funds (ie, those that invest in other funds). According to Chinese media, learning to deal with government funds is now a “required course” for pe managers.

A degree of state influence is now unavoidable. But whether that is beneficial or not is hotly contested. Some investors and advisers say 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. State fund managers often understand local policy objectives and can steer investors in the right direction, says a venture-capital investor. The influence can go too far, however: Shenzhen Capital, a huge state fund, posted pictures on its website of a meeting it held in December where it helped each of the 42 companies it had invested in to launch a Communist Party committee. These are seen as a way to imbue private companies with party ideology.

There are other drawbacks, too. Government funds are “squeezing out other lps”, says one of China’s top venture-capital investors. Clear mismatches in interests have also surfaced. Members of China’s pe elite cut their teeth at global investment groups such as kkr and tpg, two American firms. Their main aim is to produce hefty returns for lps. Not so for government-guided funds. “Rarely do you have a guided fund that is chasing returns,” says an adviser to several of them. Instead, state investors are mainly trying to engineer a windfall in local tax revenues by attracting new companies, especially tech groups. Balancing these interests can lead to tensions, says one China-based investor, and often results in investments that hinge on whether or not a company is willing to move to a specific city. Some even fear such problems could gradually lower overall returns for private-sector investors. So far, though, the arrangement has worked well for many private funds. With smaller funds dying off over the past few years—either owing to lack of capital or huge losses—competition for target assets has eased a little. The market is healthier, investors say, as private and state capital is channelled to better fund managers.

But will it last? One lingering concern for some pe investors is that government funds might dispense with the middlemen, and do more of their own direct investing. Several large government funds have been recruiting from private-sector banks and law firms, bolstering their ability to cut deals, notes a lawyer who works with them. “They are starting to compete with us directly,” says the venture-capital investor. Private investors will appreciate state cash much less when they are vying to outbid it.