Editor's note: China's venture capital and private equity industry have undergone huge shifts over the past few years, thanks to a sea change in the global and domestic socio-economic climate.
As Chinese businesses struggle to adapt to the new normal, marked by more stringent regulatory oversight against overseas listings, a Covid-battered economy, and dwindling household consumption, and stronger headwinds as startups move up the value chain, so will their financial patrons.
How are VC/PE investors faring in these turbulent times? What are the challenges they deem the most intractable and what are their solutions? Conversely, which are the emerging areas of opportunities that can be turned into the next money-spinner with their Midas touch? More generally, how do they expect China's entrepreneurial scene to evolve in the next couple of years? And most importantly, after having their finger on the pulse of the country's innovations, are they still China bulls or have turned perhaps into China bears?
These are defining questions to which no one has the exact answer. But we at EqualOcean believe that one can at least get a glimpse into the future of the Chinese economy by looking at how VC/PE investors are planning and making their moves.
With this in mind, we start a new series called "China VC Interview," in which our analysts will sit down with frontline industry practitioners to hear their opinions about China's VC/PE industry.
The following is the first in this series, conducted by our analyst Zoe Huang after her talk with Zhou Mi, a partner at Puhua Capital (Chinese: 普华资本).
Part 1 Dialogue with Mr. Zhou about the changes in China's venture capital industry
Zoe: What was the situation of China's venture capital industry when Puhua Capital was founded?
Zhou Mi: 2016 was the first year that our capital invested in healthcare, now we are in 2022. Many changes have taken place in the past six years. Looking back, I realize that 2016 is the starting point of the transition period in China’s venture capital industry. Perhaps we can make a comparison from the perspective of the classical American fund style and the new fund style formed in 2016.
Before 2016, classical American-style funds mainly operated USD funds and focused more on the promising angel, Series A, and Series B funding rounds. In terms of operation mechanism, the investment process mainly consisted of deal sourcing, deal screening, deal evaluation, and then execution and post-investment management.
Since 2016, venture funds have gradually begun to diversify. Firstly, other than USD funds, CNY funds have gradually become dominant. Secondly, in terms of investing stages, investors began to focus more and more on the mid-to-late and pre-IPO stages.
In addition, one important concept is emerging, which is that "industry plus capital forms the new drivers.” Building an industry ecosystem has been a trend. This is particularly evident in the healthcare sector. For example, we seldom dived deep into the entire value chain of the industry to evaluate all the upstream and downstream sub-sectors. Nor did we cooperate with listed medical enterprises and healthcare providers and researchers.
Since 2016, the investment style of combining "industry, academia, research, and medical services" has become the norm. Accordingly, the skills required of investors have also changed.
Zoe: From the perspective of investors, how do you think China's venture capital industry has evolved?
Zhou Mi: From the perspective of investing style, before 2016, the logic of our healthcare investment was similar to that of investing in the TMT industry. The VC industry has a unique set of work patterns, analogous to consulting or investment banking.
Since 2016, the style has become more eclectic, and the requirements for investors have become more varied. Investors need to have a deep understanding of the industry no matter what industry it is. Furthermore, it is crucial for investors to have a wide range of connections, and it is necessary to have the ability to connect and integrate all value chains in the ecosystem.
Secondly, from the perspective of VC evolution in China, the early classical VCs are in the ascendant, creating lots of myths and legends, especially in the TMT field with "rapid success.". A home run will bring considerable IRR for fund investors, equivalent to 10 to 20 normal deals. After 2016, such opportunities began to shrink. At present, if we cannot invest with a more refined, focused, and specialized approach, we will face the risk of an increasing proportion of losses.
Zoe: What do you think are the changes in the deal types?
Zhou Mi: Classical VC is more risk-seeking with aggressive operations. Currently, we need to be more cautious as the speed of profit creation has gradually slowed down. Our investment focus has shifted from consumption to hard-core technology, including healthcare and Medtech. The characteristics of tech start-ups require longer accumulation before the payoff. Thus, we need to pursue a higher success rate and a lower tolerance for mistakes.
Correspondingly, from the perspective of investors’ capabilities, in the past, the keen discernment of investors was decisive. We sorted out good start-ups through extensive screening and achieved handsome returns through quick operations. Reversely, the current situation tests the investor's capacity to integrate the value chain and capital and to create an ecosystem in order to lay a solid foundation for the creation of added value and multiple exit potentials of deals. If previously we sprinted, now the qualities of marathon runners are more needed.
Zoe: Apart from the observations above, what also makes you aware of the changes?
Zhou Mi: From an industry insider’s perspective, I feel the domestic CNY funds have dominated the market. On top of that, local governments participate frequently in deals. Nowadays more and more funds are from state-owned capitals with policy-oriented investments. Observing the new rules of the game promptly and adapting to policy needs while maintaining excellent financial performance is at the top of our agenda. Puhua Capital has done a good job.
Since the establishment of the Puhua Healthcare Fund, under the leadership of Chairman Cao Guoxiong, an advisor to the GEM’s medical sector, we have built a professional investment team internally and forged deep cooperation with major universities externally, and hired a number of medical experts as consultants to dive deep into the healthcare ecosystem.
Part 2 Investment philosophy of Puhua Healthcare Fund
Zoe: Puhua Capital has been focusing on healthcare for many years, and has invested in Micro Tech Group (688029), Everest Medicines (01952), Genor Biopharma(06998), Hu Qing Yu Tang, Huatong Pharma (002758), Jingxin Pharmaceutical (002020), Quan Yuan Tang(833409) and other renowned listed companies. Could you share with us your unique investment philosophy?
Zhou Mi: We systematically invest in healthcare including precision therapy, artificial intelligence, medical robots, healthcare big data, medical services, and insurance. Our philosophy is reflected in the selection of deals. In addition to analyzing the technology, product, team, and market dimensions of a project, we pay great attention to the following aspects:
Firstly, whether there are "unmet clinical needs" is the starting point for the evaluation of the general attractiveness of a sector. We must first focus on unmet needs. This is how we measure the value of a product or a service. We tend to assess a deal from this standpoint.
We attach huge importance to the comprehensive capabilities of the founders and the complementarity between members of the founding team as well. Many projects are attractive from the perspective of technical innovation and market growth, but most of the time the comprehensive ability of the founders and the team’s complementarity determine whether we invest or not.
Moreover, we are very interested in the start-ups' abilities to resist the price reduction of the VBP policy (Volume-Based Procurement), namely, the bargaining power in pricing. VBP has even become an industry killer over the past few years and has even had a huge impact on listed companies. Therefore, we place a high premium on bargaining power in pricing. Strong bargaining power is reflected by the uniqueness of products, competitive positioning, and patients’ stronger willingness to pay.
Zoe: Puhua Capital set up an office in London, the UK in 2017. So far, it has established three overseas growth funds, mainly focusing on high-tech fields such as life science devices, biotech, semiconductor, and artificial intelligence. In addition, Puhua Capital has also built cooperative relationships with the CVCs of titans such as Roche, Merck, Pfizer, Intel, Novartis, Google, etc. Please share with us some of the investment deals you led.
Zhou Mi: Puhua Healthcare has invested a total of CNY 2 billion across 100 deals, including 80 domestic ones and 20 from overseas. One of the star deals that we are proud of is Oxford Nanopore Technologies, an Oxford University nanopore sequencing company. ONT is a worldwide leader in third-and fourth-generation sequencing. The founding team developed a gene sequencing tool that penetrates DNA through the disintegrated double helix structure and uses a unique current signal to determine the sequence of pairs. Unlike existing solutions, this technology is fast to deploy with low cost and can provide real-time sequencing as well. As a result, it has been applied to precision medicine. We invested tens of millions of dollars. In 2021, the company was listed on the London Stock Exchange, and the market value reached USD 6.8 billion.
Another star deal I would like to share with you is the first healthcare company to list on the STAR market, which is the Micro-Tech Group that you just mentioned. The STAR market used to be phenomenal, and Micro-Tech was also the first listed company in the healthcare segment. We invested before IPO and helped the company with its product innovation improvement throughout the process, such as its flagship product, the Harmony Clip. When it was initially launched, there were many problems with hemostatic closure products. Through the good relationship established between the R&D team and clinicians, they continuously communicated with each other to obtain clinical feedback. It took one year to solve the problems and created the star product "Harmony Clip" for hemostasis and closure, which was greatly welcomed by clinicians as soon as it was launched.
These two investments mirror the concept I want to emphasize - translational medicine. Translational medicine is our essential methodology. We believe that the core proposition of our healthcare fund is the clinical and commercial translation of intellectual property or scientific achievements. It requires the synergies of the five-in-one system encompassing “industry, academia, research, medicine, and disease.” VC agencies and governments are the important drivers behind it.
Part 3 Opportunities come along with challenges
Zoe: How do you view the challenges confronting the VC industry in 2022?
Zhou Mi: The beginning of this year was rather eventful. The outbreak of the Russian-Ukrainian war and the Omicron variant surge in Shanghai and the whole country sent the stock market plunging, as prices on primary and secondary markets were seriously inverted. This put higher pressure on the primary market because of the issue of high valuation.
In terms of the fundraising environment, the sharp drop in US, Hong Kong and Chinese stocks has called for deal revaluation, which has dealt a blow to the confidence in fundraising. Over the previous two years, the dividends of China’s stock registration system and HKEX’s 18A policy have enabled biotech companies to be listed in Hong Kong with relative speed. The situation has been completely reversed this year, which will constrict the capital flow to a certain extent. Secondly, deals in the past two years were often over-valued, which resulted in a slowdown of new financing rounds and may reduce the overall transaction volume.
Simply put, although investors are relatively mature, both fundraising and exit have been adversely affected due to the general environment.
Zoe: After talking about the challenges to the industry, where do you see opportunities?
Zhou Mi: In terms of opportunities, as Buffet once said, "Only when the tide recedes will you know who has been swimming naked." Although we are now facing difficulties in fundraising and exit phases, the flip side is that there will be more targets to choose from in the market, and the revision downward of valuations will reinforce investors' bargaining power. In such a sluggish environment, excellent and powerful funds have more opportunities. For example, Puhua Capital has not slowed down the speed of investing, with little disruption to the rhythm.
From an investor's point of view, many things that happened in 2022 are beyond expectations. So far there have been many turbulences and adjustments, and negative sentiments will peak soon. But this is also a peculiar period: now is the time to test the investors’ patience and capabilities. For example, do not get lost amid the turbulences, inspect the industry chain more rigorously, and select better targets. It is essential to adhere to the original intentions, use scientific methodology, and have the courage to act and negotiate.
The multiples of return will be much more guaranteed in the next improved periods. Despite the market volatility and cycles, I still have strong faith in the fundamentals of the Chinese market, as long as I keep being patient. Challenges and opportunities are just two sides of a coin.
Personally, I entered the venture capital industry in 2008. This year has been the 14th year. I experienced the financial crisis in 2009 and the boom of the classical venture capital model led by TMT from 2011 to 2015. Since 2016, CNY funds have dominated, and the policy orientation has become more and more obvious. Having experienced many ups and downs, I believe that venture capital will tide over the tough period and usher in new opportunities.