U.S. dollar fundraising by private-equity firms that invest mainly in China has all but dried up. The days of large and easy profits are also over, as the country’s internet gold rush has ended. Chinese companies are finding it increasingly hard to go public in Hong Kong and the U.S., limiting many private-equity funds’ exit strategies. Chinese funds’ returns for the last two years have also disappointed investors.

“China-focused private-equity firms are facing challenges that were difficult to foresee a few years ago,” said Angela Lai, head of Asia Pacific and valuations at data provider Preqin. Dollar-based private-equity funds that have at least half their capital invested in China raised just $1.4 billion in the first half of 2023, down around 89% from last year, according to Preqin’s data. Global private-equity fundraising fell around 15% over the same period.

The rapid rise of U.S. interest rates since last year has created headaches for private-equity firms all over the world. It brought an end to more than a decade of cheap money and low bond-market returns, which had made private equity and venture capital extra attractive to investors.

Private-equity firms that invest mainly in China face a host of other hurdles, including the country’s stumbling economic recovery, a slump in stock-market valuations and a growing reluctance among international investors to allocate money to Chinese assets.

Private-equity firms have a model that is essentially simple: They raise money from institutions and buy stakes in companies they believe will become much more valuable in a few years time. They collect profits when the companies go public or are acquired, or by selling their stakes to other buyers. That was almost a sure-win proposition during China’s recent tech boom, but is no longer a given.

Chinese internet companies had been a lucrative bet for private-equity funds, making up a large chunk of the gains they made in the country. But after a government-led industry crackdown that began in late 2020, the valuations of many companies fell dramatically.

Ant Group, a giant fintech company, was valued at more than $300 billion in 2020 when it was planning to go public. Investors including private-equity funds Carlyle Group and Warburg Pincus were poised to collect a windfall, but Beijing scuttled the deal at the 11th hour and tightened its oversight of China’s internet sector.

In early July, Ant estimated that it was worth $78 billion, well below the $150 billion private valuation it notched in the summer of 2018 during its last private capital raise. In the midst of the ensuing industry crackdowns, TikTok owner ByteDance, another highly valued private tech company that counts private-equity funds among its shareholders, shelved its IPO plans.

In 2022, the average annual return for China private-equity funds, including venture capital funds, was minus 5.6%, according to estimates from data-analytics firm Burgiss. That was the lowest since the global financial crisis in 2008, although it was better than the global average last year.

Some managers of Chinese private-equity funds have stopped traveling to the U.S. to meet with potential investors in the hopes of raising money, because demand has fallen so much, said Marco Klaus, the chief investment officer at Silverhorn Group, an owner-operated investment firm in Hong Kong. U.S.-China tensions have been a major deterrent, he added.

The Biden administration is preparing an executive order to curb venture-capital and private-equity investment in China and other countries, The Wall Street Journal previously reported. U.S. university endowment funds, many of which used to be big backers of China-focused private-equity funds, have been asked by the State Department to disclose and divest Chinese assets.

Initial public offerings, which have been a traditional way for private-equity firms to cash out of their investments, have started to bounce back in the U.S. But IPOs in Hong Kong—the main international listing venue for Chinese companies—raised just $2.2 billion in the first half of 2023, down 16% from last year and well below 2021 volumes, according to Dealogic.

Private-equity funds in China have been investing more in industries that are favored by Beijing, including semiconductors and electronic devices, manufacturing, biotech and healthcare, according to BDA Partners, an advisory firm. The belief is that these sectors “have more sustainable growth potential,” the firm said in a recent report.

Private-equity firms’ own investors are also becoming more pessimistic about China’s prospects. Late last year, less than a fifth of investors who responded to a Preqin survey viewed the China private-equity market as presenting the best opportunity among emerging markets, compared with 46% a year ago and 55% in 2020.

Getting out isn’t easy for investors who have committed to private-equity funds, since they are often locked up for a decade and have to stump up more money if the fund managers make a capital call.

Market participants and analysts expect more activity in the secondary market, which gives investors the option to either cash out from their stakes in private-equity funds, or move their holdings into so-called continuation funds.

“There’s a lot of dislocation and it is a difficult time now for buyers and sellers to agree on what China assets are worth,” said Lloyd Bradbury, head of Asia private capital advisory at Greenhill & Co., a New York-based boutique investment bank.