What Lies Ahead for VCs in China?
In the past month, the stocks of Chinese companies listed in the US and Hong Kong experienced significant volatilities. The most direct cause was the regulation tension between the US and Chinese regulators, more specifically, the Holding Foreign Companies Accountable Act, which would allow the SEC to delist Chinese companies from US exchanges if American regulators cannot review company audits for three consecutive years.
The VC market in China is a special case, the exit opportunities are divided into two major categories — in China and overseas (mostly US and Hong Kong). To be listed in China, the companies’ investors need to invest with Chinese currency RMB. To be listed overseas, the investors need to invest with US Dollar. The VC funds, as a result, are designed as either an RMB vehicle or a USD vehicle.
Beginning in summer 2021, The USD VC funds started to receive more and more pressure from their LPs, mostly due to the increase of regulation in the Chinese education sector. The swift and determined actions severely undermined the operations and revenues of many education companies in VC funds’ portfolio. The LPs were doubtful about the future of early and growth stage investments in China, and SEC’s regulation actions towards Chinese companies listed in the US did not help.
However, the USD VC fund managers in China had mixed reactions to the situation. On the one hand, the top-tier fund managers such as Sequoia China have increased their fund-raising target. They believe that the time has come for them to invest in more companies with more reasonable valuation. On the other hand, many fund managers decided to decrease their target fund size, or even began to halt fund-raising efforts. These funds have relatively smaller AUM and lower performance compared to the top-tier managers.
For the past six years, I worked in a fund of funds focusing on VC managers in China. Given the recent events, a new chapter of VC industry is coming in China. Although many companies backed by VCs created huge alpha with creation of new products and services, efforts in optimizing operations, and synergy in business units, the value that venture capitalists were creating came largely from low-hanging fruits. In the last two decades, the size of total VC market grew over 100x, creating considerable beta for the players in the market. The beta was a result of high growth of the Chinese economy, lack of mature regulation, and a healthy geopolitical environment in the world. These factors are facing challenges in recent years. COVID-19, the trade war between China and the US, the war in Ukraine, and other major events had severe impacts on the market beta. For the fund managers in China, it is a crucial time to reconsider their investment thesis and fund-raising targets. Competition will keep increasing, and a considerable number of VCs will be washed out. Without the high beta from macro economy, fund managers should increase their ability in seeking companies that will out-perform the market, therefore maintaining the trust and support from their LPs. Instead of looking for deals in the over-saturated traditional industries such as consumer and to-C Internet services, it would be wise for the managers to start focusing on companies with solid technologies in sectors such as blockchain, semiconductor, healthcare, and cybersecurity.
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