After the Mania, China's VC Investment is Cooling Down
COVID-19 and China
The financial capital of China-Shanghai. Image credit: Denys Nevozhai/Unsplash

In terms of the financial market, China is still a young player and eager to develop. The youngest of the young is venture capital (VC), which relies on a solid financial infrastructure such as a regulatory system, a strong economy, open market, ways of exiting, etc.

As the history of VC can be traced back to the early 20th century, China did not start its own VC chapter until the mid-1980s. China founded its very first state-owned VC, China New Tech Startup Investment Company (CNTSIC, 中国新技术创业投资公司) in 1985 in order to invest in the high-tech industry. Due to the market's immaturity, the restraints on exits and other operational difficulties at the time, CNTSIC failed to make it through and was shut down at the dawn of the new VC era. Yet, VC was still a relative 'nobody' until the 1990s, which was the time that China's economy started to boost.

There are three critical periods in China's VC history: i) the end of the 1990s; ii) mid-2000s; iii) the beginning of the 2010s. The first period was the story of the domestic VC which were mostly state-owned or state-owned-enterprise (SOE) funds. The first batch of funds matured in the mid-2000s and a new wave of VC featuring dollar funds came in bundles. At the time, the stock market was the ideal exit for investors and Chinese companies rushed into the US stock market in 2004. As China's economy started growing fast and the financial market became more inclusive, VC gradually stood on its own two feet and thrived from the challenge. 

1998 – 2002 Dawn

Nearly 80,000 operating private equity (PE) funds registered with the Asset Management Association of China (中国证券投资基金从业协会) as of September 2019. The prosperity of the PE investment market today was hard to imagine two decades ago for several reasons:

  • The financial market was at an early stage and yet to mature.
  • M&A and stock exchange are the two major points for PE investments.

The first Chinese stock market, the Shenzhen stock market, was established in 1989. Later, in 1991, the Shanghai stock exchange was founded. The regulation of the stock market at the early stages was considerably stricter and circulation was not as fast as in Western ones. Bourse management teams were cautious of loosening regulations since the new market was vulnerable to any possible impact.

As to another major exit M&A, the APAC region counted for only 11% in global M&A transaction value for the year of 2018. China, as a part of APAC, still has a great space to grow in the M&A business. The maturity of the M&A market will facilitate the PE investment as an option for exits. However, 20 years ago, M&A was not a trend in China as an exit point for investors.

  • The openness of market and regulation concerned investors in 1990s

In the 21st century, China's asset management market has been gradually opening in different dimensions, especially after joining the WTO in 2001. As early as the 1990s, few foreign companies (i.e. IDG) came to China to do investments while the regulation system was yet to be built and the market was not ready to welcome global investors.

The urge toward openness in the financial market reflected the central government and in 1998, the 'Proposal of Using a Reference from Western Countries to Speed Up Mainland China's Venture Capital Industry,' also known as the 'No. 1 Proposal,' was submitted. The Proposal raised VC to be the most popular topic in the economic field and prompted the related policy's publication in favor of VC's development.

Approaching the millennium, a mix of several drivers advanced the emergence of China's VC industry. The fast-growing economy, the return of Hong Kong, the Third Industrial Revolution and even more are urging VC to grow.

A robust economy sets the foundation of the financial market and breeds a wealthy class, which raises the potential LP of VC funds; Hong Kong's return drove China to accelerate the financial market construction from regulation level to practice doctrines. Meanwhile, the Third Industrial Revolution's influence spurred China's local Internet startups. At the end of the 1990s to the early 2000s, Internet startups such as Baidu, Alibaba, Tencent, Souhu were founded. Those newborns grew into giants and stretched to areas outside the Internet in the next decade.

The development of these Internet giants was a success for those VC that supported behind. After the 'No.1 Proposal,' more than 40 state-owned or SOE-owned funds were founded by the end of 1998. According to the Ministry of Science and Technology of the PRC, the number of VC institutes in China increased from 2005's 319 to 2016's 2,045.

2002-2014: Blooming

China's VC welcomed a golden age in the first decade of this century not only because of the more opening market but also the continuously fast-growing economy. After joining WTO, the market is more opening to the world and the import and export volume supports the fact. China had planned to double the GDP to USD 4 trillion at the end of 2020 in 2000, but the goal was achieved in 2008 - 12 years earlier than the plan. The statistics of 2018 exceeded USD 14 trillion.

After the accumulated wealth and intensified communication to the world, the financial market responded to the globalization call. Dollar funds embraced a renaissance in China in the first decade and dollar investors became a major component of China's VC investors.

By far, among the top 10 China VC institutes, 8 out of 10 were founded during the first decade of this century. IDG entered China as early as 1992, while Sequoia is one of the oldest VCs in the world.

Since its founding, IDG's investment deal count has passed 1,000 so far. The first time that the annual investment count exceeded 1,000 in China was only 8 years ago. It is undeniable that China's VC industry was nearly inactive compared to the US equivalent at the beginning of the last decade. From 2001 to 2004, the average investment count was less than 40 per year while the number for the US was 1,489.5 per year. The number of VC companies determined the capacity of VC investment in startups. Inversely, China’s startups got strong financial support because of VC's rise.

As the number of VC institutes increased the deal count increased proportionally. China's VC scene has been burgeoning along with economic and technological development. As the market opened, China's companies chose to go IPO in overseas stock markets, which later became an important outlet for China's investors. The US and Hong Kong stock markets are the two most-chosen places for local companies to go public.

A remarkable event in this page is that C-trip (携程, CTRP:NASDAQ), a travel service provider, went public in 2003. Its founder Shen Nanpeng (沈南鹏), who later founded Sequoia China in 2006, is now praised as the VC Godfather of VC for his later investment practice – 12 companies in his portfolio went IPO.

China's VC market took 15 years to go from 30 investments in 2001 to 14,304 investments in 2015. The journey has not been smooth. China's financial market is still young compared to the western world's – to catch up with these mature markets, time is the solution. No one dares to rush the market to be as open as the west without considering the possible impacts and consequences.

Post-2014: From mania to cool-off

As it entered its second decade, VC in China entered its manic phase. A single investment with a deal value of over a billion dollar is not as surprising as it was in the last decade; a company receiving several regular rounds of financing in a year is not as rare as it was a few years ago; a startup becoming a unicorn within three years is not as uncommon as it once was.

2015 was the first time that China's VC investment was more active than that of the US; while 3 years ago, the investment deal count was only 1/4 that of the US. Rather than regular asset management companies, pension funds, corporate funds, and other funds joined and diversified the investor types – Tencent was the most active corporate VC and also one of the top 10 VCs in China. Alibaba is another rising force in corporate VC.

The peak was reached in 2016, when 16,000 VC investments were settled. The deal count has continuously dropped ever since. The cooling-off process lasted until the end of the third quarter of 2019, the VC investment count was merely more than half of 2018’s statistics. The deal value might welcome the first drop after 2012.

New investors flooded into the market looking for future unicorns. With the strong competition not only among startups but also among investors, China's numerous startups grew up with astounding speed – most of them were just big startups instead of fully-grown enterprises.

There is a documentary film about China's startups called Startups (燃点), and a famous VC-backed company ofo (小黄车) is one of the stories featured. ofo, which fell from a great height eventually, was once the superstar among Chinese startups. Founded in 2013, the company received more than USD 2.5 billion before March 2018. Its branches once stretched to other continents and its story inspired a lot of followers.

The bicycle unicorn was fed up with big-name VC. It grew too fast to manage its own operations. Rapid expansion burned the money and the intensifying competition led it to speed up the expansion. Capital accelerated its growth but also the exposure of its hidden problems hidden in the management team and rounds of funding. After 2018, ofo stopped its expansion, retreated from the overseas market and struggled to meet users' deposit withdrawals. ofo has become an anecdote on the street and a reminder for startups and investors about the mania time.

VC is financial support to elevate startups to scale-ups. When support is too strong during the intense competition, the foundation of startups will be more shaken when the size gets bigger in a short time.

China’s economic growth is deaccelerating, and the environment is less favorable for startups and impacts on investors’ confidence. While local investment is cooling down, investors are starting to eye the overseas market. APAC is the region where China’s investors are actively seeking opportunities. Southeast Asia welcomed a considerable number of Chinese investors, who have strong confidence in a market that shares a lot of similarities to China – a fast-growing economy, dense population, developing and a blue ocean for VC.

For any company or industry, developing too fast is a sign of danger. The foundation of a company or industry needs time. Growing too fast or expanding too aggressively with a shaky foundation is like building a skyscraper with mud. The cooling-off market gives once overheated industries and startups the time to calm down and inspect their own bodies to prepare for coming challenges and growth.

It is time for investors and startup founders to examine their practice and think about the future. Whether the new technological development will bring a new wave of investment or the new business model will reshape the industry are some of the questions for practitioners to think about before diving in. In a time filled with uncertainties, risks and opportunities are two sides of one coin. The World Innovators Meet 2019 (WIM2019) invites investors and startups to talk about the most concerning and the most exciting going on, on Dec 6-8 in Beijing.

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