The Compression of Venture Capital in China

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A continued crackdown on the continent’s tech giants and narrower IPO routes could permanently diminish the outlook.

The easy world of Chinese tech start-ups is no more.

For one thing, they’re on the wrong side of the jigsaw of the market. When valuations rose for public stocks and investors were willing to pay almost anything for future earnings, private investment markets took advantage, as many tech start-ups looked very cheap in comparison.

Now the reverse is true. With the Shanghai China STAR composite posting double-digit percentage declines over the past year and Hong Kong’s Hang Seng TECH index down nearly half, those same startups look a lot more expensive.

A relentless crackdown on Big Tech

Many are also feeling the impact of the nation’s widespread crackdown on big tech that started with Alibaba in 2019 and then spread to Didi, Tencent, education companies, insurers — and even individual influencers.

Big tech also bought out most start-ups until recently, according to a regional venture capital industry source. This has become much more difficult, especially given the new obstacles which seem to appear constantly, said the same source.

All of this initially affected late-stage private companies, or those considering imminent IPOs, but many of the negative factors have now trickled down to early-stage private companies, which are typically young start-ups.

Me too business models

These start-ups are also facing greater scrutiny given the dramatic decline in valuations and the fact that many had “me too” business models. They have mostly used small apps or technological enhancements to move real economic activity to the digital realm. Or they were just trying to grab a piece of the big tech market.

The source said the government measures have also prompted many investors to try to read the tea leaves of expected future regulations before investing.

“People spent a lot of time trying to figure out what the policy was and what areas were going to be good for investment and that led to a shift to chip companies, the automotive sector and electronic vehicles – although that seems to have played,” the source says.

No U.S. IPO

A big problem many start-ups face is that most are offshore entities, not domestic ones, and structured similarly to Alibaba, Tencent and Didi. This would prevent any type of local IPO. And given that the path to IPOs in the United States has effectively been blocked, they have very few places to go.

“The A-share market is not very good at providing liquidity to insiders and it is not really available to them because it is an approval system and not a registration process – and they won’t allow thousands of IPOs – so the question now is where do you IPO? asked the source.

Sweet approval

According to the source, Hong Kong is a possibility for start-ups, but any IPO candidate will need some form of soft approval from the China Securities Regulatory Commission (CSRC) and the Cyberspace Administration of China. (CAC).

There are also relatively few private equity funds capable of taking over the venture capital market and restructuring these companies, although this may now change.

“The world is not ending. It just got more complicated, and China is still extremely hard to ignore. When it comes to liquidity, the US market was the biggest pool of capital and they understood tech companies the best,” the source said.

“Who is your buyer when you are a small company with a market cap of $200-300 million? In the West, you sell yourself to Salesforce, Facebook, Amazon because those companies are constantly buying things,” the source said.

Some things stay the same

The same source said the market is unlikely to completely dry up for the biggest companies, as they will likely be able to continue listing overseas, and in Hong Kong – with SenseTime a recent example of this.

Qi WangCEO of MegaTrust Investment (HK), an equity manager in China, agrees that today’s market has changed.

Many technology start-ups in AI, big data and fintech are no longer being acquired by Alibaba and Tencent, which could lead to more cross-industry deals in China that mirror the recent Wealthfront purchase of 1, $4 billion by UBS, he said.

Tensions in the private equity market

Wang said there is likely more stress in the Chinese private equity industry given the five- to seven-year exit window.

“Each of these funds may have 20 or more transactions and need a number of IPOs each year to meet redemptions and other liquidity needs. The longer you wait, the bigger the problem you will have at the end of the seventh year – because then you have to return the money to the investors,” Wang said.

Another problem he cited is that Hong Kong is currently the only IPO market for China-based start-ups and has become very crowded.

High costs

Usually, companies will have gone through a three-year preparation cycle during which they manage themselves as a listed company, which is expensive.

Not all companies are happy with being stuck with this for a long period of time – a situation that gets worse if they have no realistic way to go public.

“Failure to go public while adhering to these very strict rules can hurt the business — or be a distraction as management should be focused on growing the business,” Wang said.

Role of government

But even as parts of the Chinese government make it harder for start-ups to raise funds or sell, other government agencies appear to support a growing number (Nikkei Asia paywall) startup agreements.

The Hefei municipal government’s purchase of 17% of Tesla competitor NIO at the start of the pandemic is a good example, as reported by the SCMP (paywall).

This activity, however, is primarily focused on larger private companies, not smaller start-ups.

Divergent trends

According to the wall street journal report (paywall), the conventional wisdom seems to be that the private equity market in China is doing well, with deals in 2021 up about a quarter from a year earlier, even as M&A activity in the set barely moved.

Norton Fulbright, a law firm, said many M&A players currently take a “wait and see” approach in China.

“As the engine room of the regional economy, any turbulence in the Chinese market is likely to be felt in the APAC region and beyond as well. However, it should be remembered that distress situations themselves present attractive opportunities for dealmakers,” the law firm said in its M&A outlook for this year.

to be left behind

Wang used to look at start-ups as an anchor or cornerstone investor, in a previous role at a major Hong Kong financial institution.

“They were calling me to get a market reading. They would say things like they had 20 million in revenue but no profit. What do you think? I still get those calls – but they seem to be getting more and more nervous,” Wang said.

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