Editor's note: China's venture capital and private equity industry has undergone huge shifts over the past few years, thanks to a sea change in the global and domestic socioeconomic 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 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 third in this series, conducted by our analyst Siren Chen after her talk with Xu Qian, Managing Partner of Redhill Capital (Chinese: 丹麓资本).
Mr. Xuqian obtained his EMBA from PBC School of Finance, Tsinghua University and graduated from the Chinese Academy of Sciences with a master's degree in science. Before joining Redhill Capital, he successively served as a deputy general manager of Shanghai Fosun Pharmaceutical (Group), managing partner of Detong Capital, and worked in state-owned institutions such as Chinese Academy of Sciences Holding and Tsinghua Investment, with more than 20 years of experience in the investment industry.
Part I Changes in China's venture capital industry
Siren: I know that you have been in the venture capital industry for many years. How was China's venture capital when you first entered the industry? How about the healthcare industry?
Xu Qian: I joined an investment company under Tsinghua School of Economics and Management and took a leap into the venture capital industry in early 2002. At that time, the representatives of mainstream investment institutions were state-owned venture capital firms such as Shenzhen Capital Group and Beijing High Technology Venture Capital. The healthcare industry was still relatively small and there were few investment opportunities. Therefore, very few investment teams specialized in healthcare. A venture capital fund will normally focus on all areas. The specialized fund for healthcare began to appear after 2014.
From 2014 to 2018, a large number of healthcare funds emerged, most of which were "new teams of veterans." The founders set up their own teams from the previous commingled fund to create the healthcare funds.
Redhill Capital, where I am currently working, was established at this stage. The founders Cherry Lu and Frank Su are both from a clinical medicine background. They left Sequoia Capital and Share Capital respectively and jointly founded Redhill Capital.
Siren: How do you think the healthcare venture capital industry has evolved?
Xu Qian: I have been working in this area for 20 years, and the changes are huge. In year 2005 and 2006, a number of dollar funds such as Sequoia and Qiming Venture Partners were established, from then on, the healthcare industry began to receive attention. In year 2006 and 2007, Mindray, Simcere and Wuxi AppTec were listed on the New York Stock Exchange successively, further drawing domestic attention to healthcare-related enterprises. The tipping point of CNY investment was after 2015 for the review policy and capital market environment began to change dramatically.
From the perspective of investors, our focus has also changed. Around 2010, venture capitalists mainly focused on class 1.1 new drugs. At that time, small molecule targeted drugs still represented a cutting-edge field in China and received strong support from the state. However, up to now, even ‘Me-better’ has been eliminated. The projects we are looking at now are ‘First in Class’ with platform technology and the depth and breadth of a pipeline. The healthcare industry in our country has indeed entered a new era of innovation.
Siren: Is there any driving force behind this?
Xu Qian: The first is the change of policy. One of the changes is opening up. In the past, we restricted the entry of overseas innovative drugs into the Chinese market to protect domestic industries. Now we are welcoming them into the fold. We compete on the same platform and use overseas innovative drugs to drive the growth of ours. The second is norms. The most typical one is the change of review policy. After the CFDA announced data verification on July 22, 2015, about 80% of the pharmaceutical enterprises withdrew their new drug approval applications after self-examination. The CFDA increased the number of staff and salary package, which eased the shortage of manpower in drug approval to a large extent. The third is to connect with the international norms. China's accession to ICH (The International Council for Harmonisation of Technical Requirements for Pharmaceuticals for Human Use) has accelerated the integration with international practices. The fourth is the control of health insurance expenses. In 2018, the National Healthcare Security Administration was established, and then the centralized purchasing and DRG/DIP (Diagnosis Related Groups/Diagnosis-Intervention Packet) payment strategies were implemented, forcing pharmaceutical enterprises to strengthen R&D and innovation ability.
The second is the change of the capital market. The listing requirements of China’s A-share market were set according to those governing the manufacturing industry, requiring enterprises to have profits and rise steadily, which is very difficult for innovative pharmaceutical enterprises. After the addition of Chapter 18A listing rules by HKSE (Hong Kong Stock Exchange) main board, the A-share market also unveiled five sets of listing rules concerning the STAR market (Sci-Tech Innovation Board). This allows pre-revenue or pre-profit biotech companies to be listed. With the exit channel now available, a large amount of capital poured in, accelerating the development of the innovative pharmaceutical industry.
The last but not the least, the return of talent from overseas. China has received a large number of scientific researchers who had studied for doctorates abroad. Some of them even have tenure. The academic skills of these people are first-class in the world. They not only brought back the state-of-the-art knowledge of the industry, but also the ability of research and innovation. It is foreseeable that in the next three to five years, the research results of these people will be genuinely cutting-edge innovation from China. These innovative medical technologies will benefit the health of all mankind.
Part II Investment logic and principles
Siren: You have participated in many well-known projects such as CytoNiche, Shulan Hospital, Liang Yihui and so on. Can you share with us some investment logic and principles?
Xu Qian: In essence, the key is to solve the unmet clinical needs. The needs include patients’ and doctors’. For instance, China is rich in clinical research resources and doctors have performed thousands of operations. It is the doctor who uses the medical devices and they know how to make improvement. In the view of Redhill, in addition to innovative drugs and emerging therapies, it is time to pay attention to innovative medical devices, high-value consumables, in vitro diagnostic reagents and digital medicine. We focus on innovative and cutting-edge technology.
Siren: Could you spotlight some portfolio companies that can reflect your investment style?
Xu Qian: The project I would like to speak about is CytoNiche, which is a "silver bullet" project promoted by myself, which means I am the only one on the investment committee who voted for it. The company is engaged in large-scale cell expansion of 3D microcarriers. The microcarrier developed by CytoNiche can be decomposed into tens of thousands of spherical porous microcarrier particles when exposed to water. The cells can be cultured on the wall, and the spherical microcarrier can be degraded to collect non-destructive cells. Professor Du Yanan, the founder of the company, graduated from the Department of Chemical Engineering of Tsinghua University with a bachelor's degree. He studied cell engineering at the National University of Singapore and finished his PhD program, and then conducted postdoctoral research at Massachusetts Institute of Technology and Harvard Medical School. Professor Du's complex knowledge structure determines that his venture has high barriers to competition. CytoNiche’s post-money valuation was CNY 200 million after Series A round of financing and increased to CNY 1 billion before Series B round within one year. The company's post-money valuation has multiplied nearly six times. It can also be seen that as long as a sector is marked by innovation and driven by demand, it will flourish in the end.
Another project is Liang Yihui, the largest innovative digital health platform in the vertical field of cancer in China. It provides high-quality original academic information for Chinese cancer doctors and patients, helps doctors and patients obtain correct academic information and assists Chinese doctors in improving the level and norms of diagnosis and treatment. It also cooperates with professional societies, hospitals and experts at home and abroad to carry out academic exchanges and education on cancer. The project completed a new round of financing less than three months after the investment funds were in place, and the post-money valuation of the company increased by about three times.
Shulan is a patient-oriented scientific and technological medical group. China's medical system is dominated by public hospitals and the top hospitals are often overcrowded. In this case, the needs of expecting a good medical environment and experience cannot to be met. The founders of Shulan are Professor Zheng Shusen and Professor Li Lanjuan. They are not only very successful in their academic fields, but also possess rare management talent. Under the leadership of two experts, Shulan has rapidly developed into a third-class hospital, and it is also the first large-scale private hospital in China that has passed the JCI (Joint Commission International Accreditation Standards For Hospitals, 6th edition) review. This early investment opportunity in medical services may be unique to China compared with developed countries and regions such as Europe and the United States.
It also can be seen from the above examples that the investors have a partiality for the projects which could meet clinical needs, possess cutting-edge innovation technology and a talented team.
Part III Coexistence of risks and opportunities in the industry
Siren: We are facing many challenges, such as epidemic, capital market turbulence and economic downturn. How do you view these risks? What kind of impact will they have?
Xu Qian: The current situation is exactly as you said, but an opportunity accompanies a crisis, as healthcare is a rigid demand.
For the crisis part, the performance of the secondary market is not good and the fallout began to reach the primary market. I presume there are three reasons. Firstly, it is a normal process of value regression. As we mentioned before, it was difficult for innovative biotechs to be listed in Hong Kong and on A-share market before Chapter 18A and the five sets of listing rules for the STAR. As the market has just been opened, there will be a certain degree of scarcity. In addition, some fund managers need to have different asset allocation, so a number of highly priced biotech stocks have emerged. The second factor is the policy influence. Medical insurance negotiation and centralized purchase have reduced the market space in many segments, and the investment logic and model have changed accordingly. The other very important factor is international relations. Simply put, Sino-US relations. Some overseas investors think that the policy risk is relatively high and they will choose to liquidate their positions. Plus, since the stock market is in a downward track, and the sell-off has accelerated this process. However, some have fallen too much from my perspective. But the market is pessimistic, so the adjustment range is relatively large.
In terms of opportunities, with China's rapidly aging population, the demand for healthcare will continually grow. Coupled with the improvement of people's living standards, they will invest more in healthcare. In addition, China has become aware of the importance of innovation and thanks to policy support and the inflow of talented returnees, I’m optimistic about the future of healthcare. Moreover, healthcare itself is an industry that is less affected by economic fluctuations. The demand for healthcare is timeless.
As for the impact, Redhill focuses on seed, angel and Series A rounds. Up to now, the impact is relatively limited from our perspective. Our current investment is proceeding at a normal pace. The institutions that focus on pre-IPO projects might be affected to a greater extent. This is because the market value of some listed biotech companies may have fallen below their valuation of Series B round. The fund participating in the later period may incur a paper loss. In particular, since the second half of last year, the stock prices of biotech firms have been falling below their issue prices on the listing day, making cornerstone investors lose money.
Also, the project with insufficient innovation will suffer a bigger blow. Its valuation will drop during subsequent rounds of funding, and whether the subsequent investment will come or not is a question in itself. The development of projects that used to be sought after has slowed down, and some may have to get through for a while by themselves.
Siren: What trends do you foresee in the next few years? Are there any undiscovered opportunities?
Xu Qian: I think the most important thing is innovation. There are opportunities in those innovative and frontier fields.
Actually, it is hard to say which segment is promising. Basically, there are few hidden opportunities, as all potentials have been mined by investors. However, there may also be some very rare bright spots, such as mRNA. Everyone joked that COVID-19 saved the mRNA technology. Otherwise, we don't know when its vaunted benefits will materialize.
Siren: What arrangements will Redhill make to deal with the opportunities and challenges?
Xu Qian: As an early-stage venture capital investor, Redhill is excellent in the performance of fund management The IRR (Internal Rate of Return) of CNY phase I fund is more than 60% and that of CNY phase II fund is even higher.
As for follow-up arrangements, we will try our best/strive to explore some early projects, participate in seed, angel and Series A rounds of funding, and pay more attention to the post-investment value addition to strengthen in-depth incubation. This is also my main task at Redhill. As my aforementioned ibio shows, I studied and worked in Beijing for years, so I am very familiar with Zhongguancun Science Park ( China’s “Silicon Valley”). I am also one of the few investors in market-oriented funds who have a comprehensive understanding of the commercialization of research findings within government agencies, public institutions and state-owned enterprises. Taking advantage of my network in Beijing, I will promote the cooperation between Redhill and scientific research institutes, such as Peking and Tsinghua University, help start-ups founded by experts and professors build teams, and allocate resources and commercialize their achievements of scientific research faster.