venturing into the scitech future

VC (venture capital) funds have gone red, playing major roles in Bejing's plan for an innovation-based economy. Published in July, State Council regulations on private investment funds launched specific VC provisions. Capital market measures fostering virtuous cycles between technology, industry and finance are awaited from the authorities. 

The scale and growth of the PRC VC industry are impressive, yet changing funding structures and an absence of exit pathways put further ambition at risk.

serious scale

A first boom in VCs came in 2006 when LPs (limited partnerships) were approved. In 2015, funds again burgeoned in number and scale as part of the mass entrepreneurship and innovation drive.

VC spending grew from C¥827.7 bn in 2016 to C¥3.16 tn in late August 2023, reports AMAC (Asset Management Association of China). Providing C¥625 bn in new capital to over 16,000 firms in 2022 alone, they made up 48 percent of equity investment, a leap from 26 percent in 2019.

The VC story has stayed in step with other state-based efforts to boost tech funding, notes Qiu Yong 邱勇 Shanghai Stock Exchange chair. Of companies listed on the startup-focused STAR board, 96 percent had received private equity and VC funds, demonstrating the funds' value in nurturing innovative firms into public companies.

from soft to hard tech

A ‘modern’ industrial system, argue PRC policymakers, is the only way to reach tech self-reliance. Rather than more internet giants, ‘hard tech’ firms are what is needed. Tech unicorns visited earlier this year by incoming Premier Li Qiang 李强 underscore this. They were developing semiconductors, autonomous vehicles, energy storage and satellites, none were producing consumer-facing software.  

Direct financing is the best for growing innovative tech companies, contends Liu Xiaochun 刘晓春 Shanghai Finance Institute. VC funds are vital, given their high-risk tolerance and patience to invest in the early years of future industry leaders. 

Finance is on notice to serve the ‘real economy’, but the domestic VC sector is not up to the task, laments Zhang Yilong 张逸龙 Shenzhen Hongran Equity Investment Fund. In the consumer-facing internet tech era, VCs could contribute their sense of which products have user attraction. ‘Hard’ tech, meanwhile, requires more actual tech expertise. Industry experience within VCs is critical, but, explains Zhang, rotating between industry and investment roles is still rare in the PRC.

changing from global to local

For the past three decades, foreign capital played an essential role in the PRC VC scene. Domestic funds drew down major funding from foreign LPs. First-generation PRC tech giants received early-stage funding 

• Tencent: $2.2 million from Hong Kong’s PCCW and Boston-based IDG (1998) 
• Alibaba: $5 million from a Goldman Sachs-led foreign investment team (1999)

But global capital’s appetite for PRC exposure is dwindling today. 

• a record low 10 percent of VC deals had even one foreign investor in H1 2023 
• President Biden signed an executive order in August 2023 restricting US outlays in specific PRC semiconductor, quantum and AI ventures
• several VCs are under investigation by the US House Select Committee on China
• rising US interest rates and a downturn in internet industries are in play as well

Domestic LPs are proliferating, gaining comparative advantage from the rising importance of domestic listings. State capital, not least GGFs (government guidance funds) and SOEs (state-owned enterprises), now make up 80 percent of private equity and VC funding, notes Cheng Jiuyan 成九雁 Beijing Equities Trading Centre CEO.

The VC industry has radically changed as a result, argues Guo Jinlu 果晋鲁 ICBC-AXA Life Insurance. Unlike foreign LPs, who are patient in expectation of good returns, domestic LPs want quick exits and investments aligned with national goals. Hard tech is capital-heavy; a decade of steep R&D and capital spending with no profit is standard. China's VCs and their LPs are ill-prepared for this, warns Zhang Yilong, noting an average holding period of just 3.3 years, compared to 8.2 in the US.

These conditions often lead to GGF capital going uninvested: VCs cannot accommodate their terms. Institutionally constrained, state capital is risk-averse, says Qu Jingdong 曲敬东 a private entrepreneur. Hence, many GGFs invest only in established, medium-stage firms rather than recent start-ups. This misses the point of ‘risk investment’: most investments fail, while a few successful ones yield serious profits. Beijing likely grasps this, calling for more long-term capital to fund VCs.

storm clouds

A desire for quick exits threatens the VC industry. Investments of many funds established around 2015 are maturing, notes Guo Libo 国立波 LP Think Tank, causing a rush to exit, above all via IPOs. Only some 20 percent of investments, reports AMAC, have successfully done so. As a result, funds are losing money: an FOFWEEKLY survey found that 34 percent of them made no profit in 2022. 

Tech start-ups should broaden their horizons beyond IPOs, argues Niu Wenxin 钮文新 China Economic Weekly. He urges learning from Silicon Valley, 95 percent of whose exits come from acquisitions by bigger firms. He notes that domestic corporate acquisition markets are weak due to a preference for leadership positions, big firms’ poor grasp of start-up value, and the absence of incentives for corporate acquisitions.

what next?

The need for change has been taken on board. Shanghai and Beijing announced pilots in late 2021 to ease VC equity transfers on their secondary markets, turning over C¥20 bn in deals by late 2022. China Securities and Regulatory Commission launched a share-distribution pilot, helping funds exit without flooding secondary markets with additional equities, causing prices to fall. 

SASAC (the State-owned Assets Supervision and Administration Commission) held a high-level meeting recently focused on boosting central SOEs’ core competitiveness via M&As. A search is on for ‘little giant’ SMEs that can fill niche tech needs, rather than more Alibaba-style platform giants.

VCs will, it is projected, fund the industries of tomorrow. But given greater Party control over finance flagged by the emerging Central Financial Commission, state-led measures to right the ship are the main drift. Merging SOE bureaucracy with the freewheeling start-up culture seems no easy task. Creating a new form of tech financing, an SOE-driven Chinese-style M&A system entails Beijing managing a delicate balancing act, not to say an Indian rope trick.