Entrepreneurial Finance in China: The Emergence of a Tech Giant
It should be obvious by now that China’s political economy is a special hybrid: politically dominated by one-party rule but economically capitalist. However, it is not completely capitalist.
China has a robust social safety net with free universal public healthcare, nine years of free education, and a massive governmental commitment to building and maintaining the modern infrastructure that makes economies more efficient. These public commitments were an essential part of allowing the Chinese to overcome the depredations of the colonial era, and they have continued to this day.
Still, after the errors of the Cultural Revolution, China’s Communist Party has embraced capitalism and the country’s overall capitalist orientation is very much in tune with the cultural proclivities of the Chinese people.
They have always been very entrepreneurial, establishing their own businesses wherever they settle. We can see this in the economies of Southeast Asia where Chinese immigrants dominate commercially, as well as in Silicon Valley where many Chinese entrepreneurs are leaders in the tech industry. While China may have begun its capitalist journey as a source of cheap labor for the global economy, the country is now aspiring to climb the economic value chain.
As wages have risen and workers are demanding better working conditions, China is endeavoring to become the technological powerhouse. China refuses to compete at the low-end of the economic value chain any longer.
To continue to grow, China must become a major player in industries that require consistent scientific and technological innovation: the kinds of industries that have always looked to venture capital and other forms of entrepreneurial finance for capital and expertise. There are signs this is happening rapidly.
The Growth of Venture Capital in China
Aside from Africa, China is the most rapidly growing venture capital market in the world. In a little over a decade, the amount of venture capital flowing into China has exploded over twelvefold from about $10 billion to over $130 billion.
The only significant downturn in China’s upward VC investment trajectory has been a dip in 2019 right before the global pandemic that saw venture capital investment decline to almost half its total in 2021.
However, the dynamism of the Chinese venture capital market has quickly recovered and is now back to setting national records. Still, this is a growth story as in absolute terms, in 2021, China received only 43% of the $297 billion that was invested in the US that year. That growth has continued into 2022.
According to GlobalData’s Financial Deals Database, there were 304 venture capital deals in China in January 2022 with an average size of $21.4 million which amounted to $6.5 billion in funding during that single month. China alone accounted for 16.2% of the total number of VC deals globally in January 2022. As such, venture capitalists are bullish on China.
China is not unlike the United States in that venture capital investment tends to be highly concentrated in specific geographic areas with the overwhelming majority going towards Beijing or Shanghai where the top VC firms are located.
Who are those firms? Active investors like IDG Capital, GGV Capital, and Matrix Partners are global venture capital firms with offices in major technology hubs including Silicon Valley, New York, and Boston as well as Beijing, Shanghai, and Hong Kong. IDG is the crown jewel of venture capital firms in China with $7 billion in assets under management. It was founded in Boston in 1992 but was recently acquired by China Oceanwide Holdings Group Company in 2017.
It was one of the first foreign investment firms to enter China in the 1990s and is a major investor in health care, autonomous vehicles, luxury goods, and e-commerce. Other firms tend to be focused explicitly on the Chinese market which speaks to how challenging it is to succeed in China.
For example, Qiming Venture Partners was founded in 2006 and is headquartered in Shanghai. It has $5.9 billion in assets under management. The firm has had a number of major successes including being an early investor in ByteDance, Xiaomi, and Bilibili. It is now very active in the advanced healthcare and biotechnology space as exemplified by a $255 million Series C funding round for Insilico Medicine, a firm that is developing an AI platform for drug developments to treat cancer.
The Politics of Venture Capital in China
The Chinese government is now focused on a “new development phase” which is impacting the technologies and industries that it prioritizes. There are three components of this paradigm:
- National security, including control of data and maximizing technological self-reliance
- Common prosperity with an explicit focus on ameliorating the inequalities that have emerged over the past few decades
- Stability, which entails addressing discontent among China’s middle class
As has been recently demonstrated in its heavy-handed treatment of Alibaba’s Jack Ma and other Chinese tech firms, the Chinese Communist Party is cracking down on what it considers to be the frivolity of video games and the dangers of an over concentration on Internet businesses, particularly those that could destabilize the economy by going into risky financial services.
The imperative to avoid China falling victim to the vagaries of Western-style financial speculation was at the heart of the government’s suspension of Ma’s Ant Financial IPO. However, this growing interference in the market is having a dramatic impact on the Chinese stock market as it becomes harder to appropriately value companies.
Rather, the Chinese Communist Party wants talent and financial resources to be devoted to advanced technologies that are vital to the long-term national interest like clean energy, semiconductors, and robotics.
For example, due to the overconsumption of coal and other fossil fuels as energy sources, the Chinese have long had to grapple with the deleterious health effects and vulnerability to geopolitical risk that they generate.
Thus, as part of its goal to reduce dependence on fossil fuels and enhance the quality of life for an increasingly militant middle class, the Chinese government is endeavoring to make the country carbon neutral by 2060 by making 20% of its energy mix derived from non-fossil fuel sources by the end of the decade. Towards that aim, the government in Beijing plans to facilitate increased investment and R&D in critical technologies by more than 7% annually which will be a tremendous boon for startups in clean energy and these other targeted areas.
China R&D Push: Accelerated investment in key sectors
China is unique in that it is making an unprecedented transition from being the country with the largest working-age population, to the one with the largest elderly population so labor-saving technologies like robotics and advanced automation are essential to economic growth.
Biotechnology will be a driving force in the creation of drugs and treatments to support this aging population. It has exploded in investment by a factor of 10 over the last five years. Uniquely, this commitment to a focus on advanced technologies has borne the most fruit relative to the U.S. in the semiconductor space: in 2021, Chinese semiconductor chip manufacturers, integrated circuit designers, and other semiconductor startups received $8.8 billion in funding versus only $1.3 billion invested in companies in that sector in the US.
This is politically and strategically important to the Chinese since their rival Taiwan is also a major actor in this industry and the Chinese do not wish to be dependent on them. As is always the case with the Middle Kingdom, the ultimate goal is maximum self-sufficiency in a world that it regards as increasingly hostile.
Consequently, Chinese entrepreneurship isn’t solely about making money, it is also about developing security and independence through the generation of “made-in-China” solutions to national problems. This imperative is impacting the direction and character of venture capital investment as VC investment usually follows the R&D investments that are the basis for fundamental innovation.
Just how political is venture capital investment in China? Nio, China’s rival to Tesla is a powerful example. In early 2020, due to the pandemic, Nio was on the verge of bankruptcy. It was unable to obtain additional financing from venture capital funds so it turned to Communist Party officials in the municipal government of Hefei in eastern China. Those officials provided $787 million in financing to acquire 17% of Nio and the company began producing vehicles there.
Additional financing was provided by the central government and the provincial government of Anhui. This peculiar form of venture financing worked as Nio was able to turn a profit in early 2021 while selling over 90,000 vehicles by the end of the year. Surprisingly, the Hefei government did not interfere further but rather took advantage of Nio’s booming share price to cash out with a 550% return on their original investment. But of the 6 largest electric vehicle startups in China, 5 had local governments as minority investors.
The “Hefei model” highlights a trend as local governments are increasingly taking minority financial stakes in private companies to promote economic development.
These governments have a lot to offer besides money as they control cheap land, have close ties with state-owned banks that can provide low-interest loans, and can grant other subsidies. Officials are willing to do this because they are often evaluated on the basis of economic performance and successes such as that of Nio can help them to win advancement within the Chinese Communist Party.
It is also important to note that while Chinese capital markets are growing, they are still nascent and exist in a country where unbridled capitalism is not completely trusted by powerful political elites. Capital markets, particularly with regards to IPO transactions, are not as developed as in the United States. This limits exit opportunities for investors. Consequently, until 2019, investors seeking to cash out in China were more likely to do so through equity transfers than IPOs. Such transfers accounted for over half of exits in 2019 versus IPOs being 20% of exits:
Recently, there has been a trend afoot of major Chinese IPOs with such transactions accounting for more than 97% of all exit valuations until a recent crackdown exemplified by the Chinese government’s halt of Ant Financial’s IPO which would have been one of the largest in history.
Also, part of the growing trade war between China and the US, Chinese companies are being restricted in their ability to engage in overseas listings to raise capital which is further reducing exit opportunities. The Chinese government views data about Chinese citizens as a national security asset and it is prioritizing control over that data by requiring data security reviews ahead of overseas IPOs.
Specifically, in July 2021, China’s cybersecurity regulator required that technology firms with more than one million users — a low bar in China — pass such a data review. All of this is inhibiting the ability of China’s companies with their vast troves of information about the country to do business abroad and hurting investors seeking liquidity opportunities.
The Dilemma of Investing in China
In China there is no getting around dealing with the Chinese government — it is that powerful. This was dramatically evidenced by the 2021 unilateral decision by Xi Jinping to order that private tutoring firms — a huge business in China — be reclassified as non-profits instead of as for-profit companies because they were viewed as being “hijacked by capital.”
The resulting selloff destroyed $1.5 trillion in wealth from the Chinese stock market. The ideology espoused by an opaque Communist Chinese leadership — not just profits — matters in Chinese markets so political risk is high. Intelligent VCs would be wise to focus on areas of investment that have been identified as vital to the national interest. This is not just because of politics but because this is where the brute force R&D spending that drives innovation will be focused.
China will be no different as its governmental R&D governments, particularly through public-private funds known as guidance funds which raised about $873 billion by the end of 2020, will provide great opportunities for startups. Moreover, investors that affiliate with companies situated in targeted industries can benefit from access to low-cost loans, political backing and tax breaks that are essential to success during the nascent phase of a corporation’s development. But in trying to promote important industries, the Chinese government may also be hurting China.
While a focus on advanced technologies is admirable, the Chinese government is actually going against its own roadmap to success. This is because China’s current successful technology giants were not picked by a government-directed strategy but rather the founders were allowed to use their entrepreneurial instincts to innovate in the private market as they saw fit.
More government intervention that restrains and contains entrepreneurial ambition could backfire and lead to malinvestment in venture capital — especially if enterprises are supported that should not be simply because they are in politically important industries. Moreover, because the industries targeted by China are increasingly in direct competition with their US counterparts, one must also be careful not to ruffle feathers in the United States. It is a confounding dilemma. Aside from Russia, perhaps nowhere is US investment so political as it is in China.
Fortunately, many industries are characterized by “coopetition” as there is a cycle of cooperation and competition occurring at the same time. Certain segments of the industry cooperate while other segments compete. The trick is to identify those areas of the value chain where it is possible to maximize cooperation while minimizing politically volatile competition.
This requires that venture capitalists have a deep understanding of the industry, the technology, and the politics in order to succeed in China. That last element along with cultural and language barriers also means that investing with a trusted Chinese partner that understands where the political landmines are is vital to venture capital investing success in China.
It requires founders who have the freedom and in some cases the courage to go where the market leads them. The complexities of operating within the Chinese context are as challenging as the technologies and industries there so it will take a uniquely committed venture capitalist to succeed in this market.