December 4, 2018 / by Pieter Verstraete

An introduction to China’s Venture Capital Industry – Characteristics and latest developments

The US venture capital industry has for decades taken the lead worldwide and is well-understood. The venture capital scene in China which has grown tremendously over the last years however remains a mystery to most western investors and entrepreneurs.This article describes a brief history of venture capital in the China and characteristics of Chinese VCs investment behaviour. In a next article I will discuss why startups and scale ups should consider to approach Chinese VCs and best practices for doing so based on my personal experience.Blistering pace of growth

Unlike the United States, the history of venture capital in the People’s Republic of China is much shorter. It was not till a few years after Deng Xiaoping’s reform policy to open up China’s economy that the concept of venture capital was developed. However, due to unfamiliarity with the concept of venture capital and the lack of a nation-wide capital market, venture capital initially developed very slowly.

It was only in the next decade that the development of venture capital in China would reach the next stage. Two major events were the basis for this. Firstly, in 1990 two stock exchanges were launched: The Shanghai Stock Exchange and the Shenzhen Stock Exchange. The second major milestone was the so-called ‘no. 1 Proposal’ during the first meeting of the 9th Chinese People’s Political Consultative Conference, which acknowledged the importance of venture capital and the urge to develop this industry. In the period afterwards, various reforms were made in order to make it easier for VCs to exit their investment through an IPO.

Fast-forwarding the last two decades, one can see a clear link between the development of China’s domestic stock exchange and VC activity. For example, after the long-awaited secondary board – the ChiNext board – was finally established in October 2009, both the number of newly-established venture capital funds and the amount of funds raised doubled in 2011. Also in recent years the strong momentum for venture capital in China has not shown any sign of slowing down. In 2015 alone, 597 new venture capital funds, collectively raising more than USD 30 billion worth of fresh capital eligible for investment, were set up in China, and 257 companies invested into by venture capitalists went public in China.

Now the second-largest VC market in the world, China’s VC fundraising nearly doubled between 2015 and 2017, in large part driven by the fruition of China’s internet universe and mounting government efforts. Of the USD 154 billion worth of VC invested in 2017, 40 percent came from Asian (primarily Chinese) VCs. America’s share? Only 4 percentage points higher at 44 percent.

The trend continues throughout 2018, whereas venture capital deals in China led global investment activity in Q2 2018, accounting for eight of the ten largest VC financings globally this quarter, including four transactions larger than USD 1 billion. Corporate VC investment in China also hit a new record in Q2 2018, accounting for nearly USD 30 billion.

China notched eight of the top 10 deals, including the record-setting USD 14 billion investment in Ant Financial, operator of Alipay – China’s biggest online payment platform. In addition, Shanghai-based unicorns Weltmeister and Pinduoduo each raised at least USD 3 billion. Other deals included Manbang Group (USD 1.9 billion), Ubtech (USD 820 million), Hellobike (USD 700 million) and SenseTime (USD 620 million and USD 600 million in two separate rounds).

IPOs as preferred exit strategy

When we dive deeper into the investment behaviour of Chinese VCs, we can easily see that they are not that much different than their western peers. The cycle consists of three stages: raising a venture capital fund (fund-raising), investing in and adding value to a portfolio company through the venture capital fund (investment), and realizing profits and returning them to the venture capital investors (exit).

Where Chinese VCs do differ from (American) counterparts, is their preferred exit strategy. The vast majority of American firms exit through mergers and acquisitions and a relatively small number through IPO, with a ratio of roughly 1:4 over the last few years. China’s venture capital firms monetize their investments mainly through IPOs, with M&As coming second. According to Zero2IPO Research Centre, a leading service provider and investment institution in China’s private equity industry, exits by private equity and VC-backed firms in China totalled 2,906 from 2008 to 2015, of which 1,374 via an IPO.

Methods of exits American VCs

Methods of exits Chinese PE/VCs

 

This clearly indicates that IPOs have been the most popular exit method for venture capital in China over the past few years. Share buybacks, for instance, are usually only opted for either when exits cannot be done via an IPO or M&A, or when the portfolio company no longer wishes to be controlled by the venture capitalist. Moreover, there are relatively more legal restrictions on share buybacks under Chinese law.

Nonetheless, there appears to be a trend towards an increasing number of M&A-exits in recent years, especially in the venture capital industry. Chinese venture capital companies are diversifying their exit strategies

Listing on the National Equities Exchange and Quotation, or NEEQ, has emerged as a key pillar of investor companies’ exit strategies, with over 1,200 investment recoveries, or about 60% of the total, made through listings on the over-the-counter market, also known as the “new third board,” in 2016. They are now regaining their appetite for investment in startups on the back of a recovery in initial public offerings on the Shanghai and Shenzhen stock exchanges, as well as the feverish OTC market. It is not uncommon for venture capital firms in China to acquire shares of around 20% in a startup in the run-up to its listing on the new third board and then sell the shares in phases afterward.

Five legal, economic, and cultural reasons can explain the investor preference for an IPO over an M&A as an exit option in China:

  1.  IPO-exits in China tend to give high returns
  2. M&As are less feasible as an alternative exit option in China because regulatory approvals are required for M&A transactions.
  3. The Chinese government has exerted stringent control over debt financing. Banks in China have very conservative lending practices (e.g. a maximum term of 7 years and the loan cannot exceed 60% of the acquisition price), making it difficult to finance both venture capital and M&A deals with debt.
  4. The preference for IPOs may be explained by cultural factors. The success of Chinese companies is strongly correlated to the personal success and network of the leadership team. Transferring this to a different party might lead to crucial connections, and hence the success of the company, are lost.
  5. The institutional infrastructure for M&As in China is underdeveloped. In an M&A-exit, a potential buyer will face difficulties getting direct access to the information of non-listed target startup companies.

Latest trends

Despite a looming trade war and Chinese government restrictions on capital outflow, China-based VC funds and corporate investments continue to pump vast new sums into everything from global biotech startups to AI-equipped robotics.

  •  Life Sciences and Biotech: Life sciences and biotech are sectors attracting increasing amounts of venture capital in China, with private equity firms and hedge funds investing heavily in startups as they look to leverage the industry’s upbeat growth potential. Healthcare services, such as IT, lead life science investments in terms of dollars and deal flow, followed by therapeutics, diagnostics and medical devices. On the back of an aging population, burgeoning personal incomes and a rapidly developing private medical industry, China’s healthcare sector will become a $1 trillion-a-year business by 2020, according to a report by consulting firm McKinsey.
  •  Robotics: Already in 2016, China accounted for 35 percent of the world’s robot-related patent filings, and Chinese investment has amounted to at least $10 billion per year.
  • Autonomous and New Energy Vehicles: Aiming to decimate traffic congestion and build new AI cities, China has a vested interest in the rapid deployment of AI behind autonomous transit.
  • New energy vehicle and automotive ancillary service projects have attracted heavy venture capital (VC) investment into China over the past six months, bolstering valuations of some automotive start-ups into unicorn status, or a private company valued at over US$1 billion.
  • Chinese tech giants – including ride hailing app unicorn Didi Chuxing, Baidu and Alibaba – have been active investors in autonomous vehicle companies as well as forging partnerships with original equipment manufacturers (OEM) to lead the country’s gradual evolution into the electric car market. Investments in China’s automotive and electric car sector accounted for half the world’s 10 biggest VC financing deals during Q2 2018.

The cooling down of the Chinese VC market

However, some Chinese VCs actually do feel the pain of a domestic economic slowdown. Chinese financial regulators have stepped up financial deleveraging measures to reduce bad debt risks. As a result, the number of Limited Partners (LPs) that invest in venture capital deals and private equity funds has decreased, along with financing from banks, shrinking the pool of cash to fund start-ups.

Capital raised by investment firms for seed funding was only 3.82 billion yuan (USD 559 million) during the first six months of 2018, a 53 per cent drop year-on-year, according to research firm Zero2IPO. Venture capital investors have had to adapt to the colder climate, either by putting on a brave face or adjusting their strategies.

During the good times in 2016 and 2017, Chinese investors chased investment hotspots one after another, from bike sharing to virtual reality (VR), from augmented reality (AR) to autonomous vending shops, raising valuations in the primary market to sky-high levels. Bike sharing firm Mobike was valued as high as USD 3.5 billion, according to Chinese magazine Caijing, but was eventually bought by Meituan in April for USD 2.7 billion. Fallout could also be seen when investor darlings such as video-streamer iQiyi and smartphone maker Xiaomi went public – sliding on their market debuts.

About the author/ the firm

Pieter Verstraete holds a degree in Chinese culture and linguistics and has adopted China as his second homeland. He knows the ins and outs of its business culture very well and has worked with multiple Chinese investors who look for strategic opportunities in the West. Pieter bridges the best of both worlds, with a unique perspective on the global evolution of business and a keen eye for the chances offered by the rapid proliferation of emerging technologies. 

Serval Management & Consulting has over a decade of experience under its belt in managing and consulting successful business mergers, acquisitions and go-to-market strategies. In particular, we help create synergies between European and Chinese firms and projects. Dividing our time between China and Europe, we are equally fluent in the cultures and business traditions of both economic areas, which guarantees your success. www.serval.management