Written by Claudia Zeisberger & Ian Potter at INSEAD

In January, Sequoia’s Michael Moritz, wrote in the FT[1] that the venture community in Silicon Valley needed to wake up to the competition posed by Chinese technology companies. His warning may have come too late. But it should not have come as a surprise: for those paying close attention, as far back as 2013, President Xi was on record saying “Our technology still generally lags that of developed countries, and we must adopt an asymmetrical strategy of catching up and overtaking”[2]. It appears as though he is now delivering on that promise.

In the most recent five-year plan developed by the Central Committee, encouragement was given to private Chinese technology firms to spread their wings globally and to seek validation and additional capital through IPO’s. Revealed as a consequence were the results of that asymmetrical competition approach: both a far deeper bench of privately held Chinese companies valued in excess of US$10 Billion than had previously been thought and a surprising lack of visibility on the scale and maturity of the Chinese venture ecosystem. What Mr. Moritz saw on his recent China trip may just be the tip of the iceberg.

A global ranking by the venture industry reference CB Insights[3] of the largest privately held technology companies in April 2018 listed 232 companies with valuations in excess of US$1 Billion (‘unicorns’), 63 of which were Chinese. A report published concurrently by a unit of China’s Ministry of Science and Technology counted 164 Chinese unicorns[4]. Moreover, within that population of Unicorns were an astonishing ten privately held Chinese technology companies with a valuation above US$10 Billion (which we’ll call ‘Red Unicorns’). This difference between Eastern and Western venture worlds needs to be better understood.

The first step is to compare & combine the two reference datasets. A simple combination of the two lists yields a surprising result: of the top five companies by value, four are Chinese.

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Sources please see below

Is this credible? A quick comparison of the reference criteria for the two reports does reveal some differences. We approached the authors of the CBI report to try to understand why they had apparently missed these Red Unicorns. According to their practice, only companies that are not consolidated subsidiaries of a larger corporation; have raised third party equity; and have a valuation in excess of US$1 Billion qualify for inclusion. Applying this definition, one Chinese company would fall out of the top five (Alibaba Cloud), only to be replaced by another (Meituan Dianpin). There is a deep bench here.

How has this happened? One reason is speed. Another is capital. Three years ago this list would have looked very different. As has been seen in so many areas, the ability of China to scale at speed is impressive. We will look more deeply into the ecosystem that has stimulated such impressive growth separately, but to make an illustrative comparison, the largest five Red Unicorns are on average seven years old with an average value of US$49 Billion. The largest five non-Chinese Unicorns were 11 years old and valued at an average of US$32 Billion. While far from scientific and even accepting that valuations may be inflated, it does illustrate the speed and scale of the Chinese ascendency.

Now that these companies are emerging (at least to western eyes) from their ‘submarine’ phase, it would make sense to understand the environment that gave rise to them and enabled them to grow so big so rapidly. Should we paint this in the colours of a battle of ideologies — a case of a centrally directed effort eclipsing the famously libertarian approach of the Valley? It could be tempting and for many emerging economies, this is a central policy question, but the answer we feel, is ‘likely not’.

In simple terms, the necessary ingredients for venture success might be summarized as talent; capital and credible institutions directed at large market opportunities. The west has had all for some time, but it is only recently that China now has them too. The accumulation of Chinese investment capital is hardly news. Nor is the prodigious talent of it scientists and engineers — global graduate schools have enjoyed their labours for years. What has changed is the maturity and support of the institutions that govern the allocation of capital, property rights and to some extent, enforcement. This has taken place in a large, controlled domestic ‘sandbox’ where foreign competitors have been constrained (which is possibly the ‘asymmetry’ that is referred to by President Xi).

More specifically, recent changes in domestic investment policy (that both focus and constrain domestic capital allocation); simplified & speedier access to (especially domestic) capital markets has driven a rapid rise the in the amount of capital flowing to venture investments in China. In 2017, reported VC investments in China reached $US$62 Billion, or almost 90% of the US equivalent. In 2018, if the current trend is extended, China will, for the first time, absorb more VC capital than the US.

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Venture Capital Flows US & China

The two main drivers of the rapid ramp of capital flows into VC are the rapid increases in domestic funds — partly as a result of capital controls, but partly as a result of an improved VC investment universe. The combination of constrained capital seeking high quality investment opportunities and a large population of high quality domestic talent addressing a rapidly changing and permeable market is powerful and the fund flows reflect

that.

Skeptics will point to the immaturity of the Chinese exit processes, the possibility of artificially high valuations, and the opacity of financial performance. All are real risk factors that could mean that the Red Unicorns’ values are overstated. What is less likely to be the case is that they are coming, they are many and they are serious about challenging the west for ownership of the future. Is this a local peak or the eclipse of Silicon Valley’s dominance? It’s far too soon to say. But what is clear is that Mr. Moritz was right to be alarmed.

This article was first published at South China Morning Post, Hong Kong

Ian Potter is a Distinguished Fellow at INSEAD; Claudia Zeisberger is a Professor at INSEAD & the Academic Director of the school’s Global Private Equity Initiative (GPEI) at INSEAD. The article draws on a student project executed by MBA’s in her PE elective with the title ‘China’s Venture Capital: Bigger than Silicon Valley’s?’

[1] Financial Times, Silicon Valley would be wise to follow China’s lead — Financial Times, January 17, 2018

[2] Xi Jinping’s Statements on a Comprehensive National Security Outlook: Selected Extracts; as quoted in the NY Times.

[3] CBI: https://www.cbinsights.com/research-unicorn-companies, as of 11 April 2018

[4]《2017年中国独角兽企业发展报告》2017 China Unicorns Development Report, March 2018

Professor of Entrepreneurship & Family Enterprise at INSEAD & Founder of GPEI; Interests: Venture Capital, PE & all aspects of Risk taking

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