China’s VC playbook is changing as US IPO exits get tougher

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A bank employee counts Chinese renminbi (RMB) or yuan notes next to US dollar notes at Kasikorn bank in Bangkok, Thailand, January 26, 2023.

Athit Perawongmetha | Reuters

BEIJING – China’s venture capitalists once famous for their big U.S. IPOs of consumer companies are under pressure to change their strategy dramatically.

The urge to change their playbook to a more modern environment has increased in recent years with tougher regulations in China as well as the US, tensions between the two countries and a slowdown in the second largest economy. in the world.

Here are the three trends going on:

1. From US dollars to Chinese yuan

The business model for famous Chinese venture capital funds such as Sequoia and Hillhouse typically involved raising dollars from university endowments, pension funds and other sources in the US – known in the industry as limited partners .

That money then went into startups in China, which eventually sought initial public offerings in the US, generating returns for investors.

Now many of these limited partners have stopped investing in China, as Washington increases its scrutiny of US funds supporting Chinese advanced technology and it becomes more difficult for Chinese companies to list in the US A slowdown in the Asian country has further dampened investor sentiment.

That means venture capitalists in China have to look to other sources, such as the Middle East, or, increasingly, money tied to local government coffers. The move to domestic channels also means a change in currency.

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In 2023, the total venture capital funds raised in China fell to the lowest level since 2015, with the share of US dollars down to 5.3% from 8.4% the previous year, according to Xiniu Data, a business research firm.

That’s far less than in previous years – the share of US dollars in total VC money raised was around 15% for the years 2018 to 2021, the data showed. The remaining portion was in Chinese yuan.

Currently, many USD funds are shifting their focus to hard-hitting government-backed tech companies, which typically target A-shares rather than US listings.

For foreign investors, high US interest rates and the attractiveness of markets such as India and Japan are also influencing decisions about investing in China.

“VCs have definitely changed their perception of Greater China in recent years,” Kyle Stanford, lead VC analyst at Pitchbook, said in an email.

“Larger private markets in China still have a lot of capital, whether it’s from local funds, or from areas like the Middle East, but overall the perception of growth in China and VC output has changed,” he said. .

2. China deposits, China out

Washington and Beijing resolved in 2022 a long-running audit dispute that reduced the risk of Chinese companies having to list on US stock exchanges.

But after the collapse of the US listing of the Chinese tourism giant Didi in the summer of 2021, both countries have increased the scrutiny of China-based companies that want to go public in New York.

Beijing now requires companies with large amounts of consumer data — essentially any consumer-facing Internet-based business in China — to get approval from the cybersecurity regulator, among other measures, before they can list in Hong Kong or the US

Washington has also tightened restrictions on American money going into Chinese high-tech companies. Some large VCs have separated their operations in China from those in the US under new names. Last year, Sequoia rebranded in China as HongShan.

“USD funds in China can still invest in non-sensitive sectors for A share IPOs, but they have the challenge of a local enterprise preferring capital from RMB. [Chinese yuan] currency,” said Liao Ming, founding partner of Beijing-based Prospect Avenue Capital, which has focused on the US dollar currency.

Stocks listed in the Chinese mainland market are called A shares.

“The trend is moving towards investing in parallel assets overseas, indicating a strategic shift ‘from long China to long Chinese,'” he said.

“Since US IPOs are no longer a viable exit strategy for Chinese assets, investors should focus on local exits in their capital markets – in other words, China going away for Chinese assets, and the US out for overseas assets,” Liao said.

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Only a handful of China-based companies—and hardly any large ones—have listed in the US since Didi’s IPO. The company went public on the New York Stock Exchange in the summer of 2021, despite reported regulatory concerns.

Beijing quickly ordered an investigation that forced Didi to briefly suspend new user registrations and app downloads. The company listed later that year.

The investigation, which has since ended, followed Beijing’s crackdown on alleged monopolistic practices by internet tech companies such as Alibaba. The ban also included after-school tutoring, youth access to video games and real estate developers relying heavily on debt for growth.

3. VC-government alignment, bigger deals

Instead of consumer-facing sectors, Chinese authorities have emphasized support for industrial development, such as advanced manufacturing and renewable energy.

“Currently, many USD funds are shifting their focus to hard-hitting government-backed tech companies, which typically focus on A-share exits rather than US listings,” Liao said, noting that it aligns with Beijing’s preferences as well.

Among these companies are developers of new materials for renewable energy and factory automation components.

In 2023, the top 20 VC deals for China-headquartered companies were mostly in manufacturing and did not include the e-commerce industry, according to PitchBook data. In the pre-pandemic of 2019, the main deals included a few online shops or Internet-based consumer product companies, and some electric car startups.

The change is even more dramatic compared to the boom around the time online shopping giant Alibaba went public in 2014. The top 20 VC deals for China-headquartered companies in 2013 were largely the e-commerce and software services, according to PitchBook data.

… the venture capital situation has become even more state-focused and focused on government priorities.

Camille Boullenois

Rhodium Group

The move away from internet apps to hard technology requires more capital.

The median deal size in 2013 among the 20 largest VC deals in China was $80 million, according to CNBC calculations based on PitchBook data.

That’s far less than the median deal size of $280 million in 2019, and a fraction of the median of $804 million per transaction in 2023 for the same category of investments, the study showed.

Many of these deals were led by local government-backed funds or state-owned companies, compared to a decade earlier when VC names such as GGV Capital and internet tech companies were more prominent investors, which according to the data.

“In the last 20 years, China and finance developed very quickly, and in the last ten years private [capital] money grew very quickly, meaning that there would be just investment in any business [generate] is coming back,” said Yang Luxia, partner and general manager at Heying Capital, in Mandarin, translated by CNBC.

Yang doesn’t expect the same pace of growth in the future, and said she even takes a “conservative” approach to new energy. The technology changes quickly, making it difficult to pick winners, she said, and companies now have to consider buyouts and alternatives to IPOs.

Then there’s the question of China’s own growth, especially as state-linked assets and policies play a larger role in tech investment.

“In 2022, [private equity and venture capital] investment in China was cut in half, and fell again in 2023. Private and foreign actors were the first to withdraw, so the venture capital situation has become even more focused state and focus on government priorities,” said Camille Boullenois, associate director. , Rhodium Group.

The danger is that science and technology will become “more state-led and in line with government priorities,” she said. “That may be effective in the short term, but it is unlikely to promote a new environment long-term successful practice.”

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