The China Venture Capital Squeeze

A continued crackdown on the mainland’s tech giants and narrower IPO paths may permanently diminish prospects.

The easy world of China’s tech start-ups is no more.

For one, they are on the wrong end of the market whipsaw. When valuations rose for public equities and investors were willing to pay almost anything for future earnings, private investment markets benefited 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 in the last year and Hong Kong’s Hang Seng TECH index down by almost half, those same start-ups are looking far more expensive. 

Sharp Crackdown on Big Tech

Many are also feeling the impact of the country’s widespread crackdown on big tech that started with Alibaba in 2019 and then extended to Didi, Tencent, the education sector companies, insurers – and right on down to individual influencers.

Big tech also bought up most start-ups until recently, according to a source in the regional venture capital industry. That has become much harder, not least given the new obstacles that seem to be pop up on a constant basis, the same source indicated.

All of this initially affected late-stage privates, or those looking at imminent IPOs, but that many of the negative factors have now trickled down to early-stage privates, which are usually fledgling start-ups.

«Me Too» Business Models

Such start-ups are also facing tougher scrutiny given the dramatic decline in valuations and as many had «me too» business models. They mainly used small app or tech improvements to shift real economic activity into the digital realm. Or they simply were trying to grab a slice of the market from big tech.

The source indicated that the government’s steps have also prompted many investors to try and read the tea leaves of expected future regulation before investing.

«People spent a great deal of time trying to figure out what policy was and what areas were going to be friendly to investment and that resulted in a shift to chip companies, the auto sector and electronic vehicles – although that looks to have played out,» the source indicated.

No U.S. IPOs

A big issue many start-ups face is that most are offshore entities, not domestic ones, and structured in a similar fashion to Alibaba, Tencent and Didi. That would preclude any kind of local IPO. And given the path for U.S. IPOs has effectively been barred, they have very few places to go.

«The A share market is not that great for getting liquidity to insiders and it is not really available to them as it is an approval system not a registration process – and they are not going to allow thousands of IPOs – so the question now is where do you IPO? ,» the source asked.

Soft Endorsement

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

There are also relatively few private equity funds around that can take up the slack in the venture capital market and do the job of restructuring those businesses, although that may now change.

«The world is not ending. It just got more complicated, and China is still extremely hard to ignore. As far as liquidity goes, the U.S. market was the biggest pool of capital and they understood tech companies the best,» the source indicated.

«Who is your buyer when you are a small company with $200-300 million in market capitalization? In the west, you sell yourself to Salesforce, Facebook, Amazon as these companies constantly buy things,» the source said.

Some Things Stay the Same

The same source indicated that the market is unlikely to completely dry up for the largest companies, as they are likely to be able to continue to IPO offshore, and in Hong Kong – with SenseTime a recent example of that.

Qi Wang, CEO of MegaTrust Investment (HK), a boutique China equity manager, agrees that the current market has changed.

Many of the tech start-ups in AI, big data and fintech are no longer being acquired by the likes of Alibaba and Tencent and that may result in more cross-sectoral deals within China that mirror UBS’s recent $1.4 billion Wealthfront purchase, he said.

Private Equity Market Stresses

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

«Each of these funds may carry 20 or more deals and need a certain number of IPOs each year to meet the redemption and other liquidity needs. The longer you wait, the bigger the problem you’ll have at the end of the seventh year – as you’ll have to then return the money to investors,» Wang said.

Another problem he cited is that Hong Kong is really the only IPO market right now for China-based start-ups and it has become a very crowded one.

High Costs

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

Not all businesses are happy with being saddled by that for an extended amount of time – a situation that becomes exacerbated if they have no realistic way of going public.

«The inability of going public while still following these very strict rules may hurt the business – or be a distraction as management should be focused on growing the business,» Wang said.

Government Role

But even as some parts of China’s government are making it tougher for start-ups to raise money or sell out, other government agencies seem to be backing an increasing number (Nikkei Asia, paywall) of start-up deals.

The municipal government of Hefei’s purchase of 17 percent of Tesla competitor NIO during the early part of the pandemic is a good example of that, as reported by the SCMP (paywall).

That activity, however, is focused mostly on the largest privately held companies, not small 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 fine, with 2021 deals up by around a quarter from a year earlier, even though M&A activity overall has barely budged.

Norton Fulbright, a law firm, said that currently many M&A players are taking a «wait and see» approach to China.

«As the engine-room of the regional economy, any turbulence in the Chinese market is likely to be felt also across the APAC region and beyond. However, it is worth remembering that distressed situations themselves present attractive opportunities for dealmakers,» the law firm indicated in its M&A outlook for this year.

Getting Left Behind

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

«They would call me to get a market read. They would say things like they have 20 million in revenue but no profit. What do you think? I still get these calls – but they are sounding increasingly nervous,» Wang said.