Venture capital in China has a short but impressive history. Over the past 15 years, the country has spawned a third of the world’s unicorns (startups valued at USD 1 billion and above). At the same time, the Chinese VC industry has expanded more than ten-fold. By the second quarter of 2018, Chinese start-ups accounted for 47% of the world’s venture capital funding, surpassing the United States for the first time.
Since then, the sizzle seemed to fizzle—VC and private equity (PE) investment in China slowed sharply in late 2018. This “capital winter” continued into 2019. As of December 15, business information provider ITjuzi reported that a total of 8,257 companies had received funding, declining 28.31% from the year before. The total value of investment also shrank by 19.01% to RMB 2.58 trillion (USD 365.77 billion).
In 2019, 336 startups ceased operations, having collectively raised RMB 17.4 billion (USD 2.5 billion) from investors. About half of the 20 costliest failures of “new economy” startups occurred last year.
These wintry days have forced Chinese investors to tighten their belts, even exiting the game. The stormy weather is also brewing globally where many uncertainties prevail—for instance, globalization and open economies have come under threat, in part due to the coronavirus and its aftermath—presenting a new set of challenges for venture capitalists.
KrASIA’s parent company, 36Kr, spoke to several venture capitalists to gather their sentiments and strategies amid this less predictable investment climate, throughs email interviews, phone calls, and in-person interviews.
Venture capital in China in the next decade
Early last year, Asia-Pacific startups based outside China raised more funds than their mainland counterparts for the first time in five years. China’s saturated tech sector and the huge untapped potential in Southeast Asia and India had diverted VC interest and their deep pockets to these new markets. Chinese venture capital investment in Southeast Asian startups grew eight-fold year-on-year to USD 1.78 billion in the first seven months last year. Currently, 18 of 30 Indian unicorns have Chinese funding.
Meanwhile, innovation at home has waned, as start-ups and VCs begin their search for the next big thing after the mobile revolution, investors told KrASIA.
Wang Hua (Sinovation): Innovation will always happen but it will no longer be driven by startups. When innovation happens in a startup, whether it wants to see it through to the end or hand it over to a larger company will also be changing.
Zhang Jinjian (Vitalbridge): I believe China’s human capital and unstoppable technological advancement will eventually drive new innovation and creations. We will see future innovation happening more frequently and rapidly.
Chen Yuetian (S. Capital): Innovation will find its own rhythm. There won’t be huge waves in future innovation but we must ride the little ones to make progress, so that when the huge wave finally comes, we will be able to surf it and not go under.
Early indications point toward three key areas where the next decade’s big innovation waves might start: emerging technologies, industrial efficiency, and strong business models.
Technology will always be a hotbed for VC funds. The next few years will set the stage for 5G-related investments, as the next-generation mobile technology will enable new businesses to emerge. At peak data rates of up to 100 times faster than 4G networks, 5G’s reduction in latency will drive everything from augmented and virtual reality (AR/VR) to smart cities and autonomous vehicles.
Fu Jixun (GGV): From 3G to 4G we saw the emergence of short-form video. What will come with 5G, AR, and VR?—there may be new innovation waves that can propel new investment.
Gan Jianping (INCE): I follow closely developments in human-machine interaction. The 80s had the game-changing mouse. The 90s had the search box that changed how people find information. From 2008, we had smartphones. What will dominate human-machine interaction next? VR glasses, projectors, or mini-robots?
China is pivoting from being the “factory of the world” to become a service-driven economy. National strategies, such as Made in China 2025 and Internet Plus, will pair modern manufacturing with high tech, including mobile internet, big data, and the Internet of Things (IoT).
The digital transformation of traditional enterprises will be expedited by the “industrial internet”—the application of technologies like 5G and cloud computing to help non-tech companies achieve higher levels of efficiency, productivity, and performance.
Niu Kuiguang (IDG): In the past 10 years, we made money from consumer internet. Moving on, consumer internet will still progress rapidly but investment opportunities will be in efficiency-driven areas.
Fu Jixun (GGV): I see two opportunity areas for incubators in China over the next 20 years —one is in local production to substitute imports, as globalization hits a wall. Another area will be industrial internet, which will improve efficiency in society.
After a number of spectacular failures in “new economy” ventures, VCs focusing on China are turning against business models that burn cash in early-stage customer acquisition, preferring to fund later-stage ventures with proven ideas, market, and profitability.
The trend has forced new ventures seeking early-stage funding to provide a path to profitability within 12 to 18 months. “Unit economics”—revenue and cost associated with the business model—is being discussed early in the process, something that did not happen five years ago.
These changes in startups mentality and valuation metrics are halting an era of reckless cash burning and kickstarting one where strong business models and cash flow prevail.
Xiong Fei (Matrix): The early days of investment in internet projects were like Zuckerberg (you have a great idea, a popular product). The next phase will be akin to Buffett (strong business model, good cash flow management). This is why vision funds are emphasizing more on cash flows.
Wang Hua (Sinovation): From the perspective of VCs, small scale fundings will be more radical but large scale investments will need to be steady and stable. This way, the funds are hedged against each other so that we can better predict profitability.
Sustainability of China venture capital in an uncertain world
VC sentiment has been dragged through a global political and economic quagmire, especially the prolonged US-China trade tension. USD funds are much more cautious compared to past years, as many cross-border deals are very tightly regulated by the Committee on Foreign Investment in the United States (CFIUS) VCs are also reluctant to invest in high-tech Chinese startups, which may be politically sensitive.
Domestic RMB funds, which make up about 75% of VC investment in China, have also been cautious. With growing hostility toward Chinese tech firms among US regulators, investors are apprehensive that these startups would be unable to list on American stock exchanges, the preferred destination for Chinese companies.
Fu Jixun (GGV): Today’s business environment is highly unpredictable. Previously, resources like talents and supplies were highly mobile in global markets. Now globalization is obstructed, so restructuring in asset and supply chains is necessary. This is our biggest challenge, but it is also our opportunity.
The emergence of COVID-19 late last year sent another cold draft into China’s “capital winter”, as it further threatened open borders and prevented investors from meeting prospective fund-seekers. Data from ITjuzi show that only 634 projects were successfully funded in Q1 2020, down from 1,143 in the same period last year, representing a 44.5% decline. Total investment value also fell by 31.3%.
After the outbreak came under control, China venture capital funding rebounded to almost the same level as last year—Chinese companies secured 66 venture capital deals for the week ending March 28.
However, repercussions from the US-China trade tension, exacerbated by the coronavirus pandemic , are expected to last well into the future. This will likely bring about permanent changes in cross-border collaborations, innovation, and financing, as countries seek a balance between protecting national interests and free exchange.
Zhou Wei (CCV): The world, in general, seems to be entering a more conservative state. However, I think Chinese start-ups and VCs are increasingly open-minded. We’re crossing borders towards better international collaborations.
Li Feng (FF): For the past 40 years, whenever we face such a challenge, the solution has always been market openness, foreign investment, and private enterprise support. As a VC, I am very optimistic that this openness will continue.
Innovation within the VC industry
Battling these headwinds, investors remain largely optimistic about the sustainability of venture capital in China. However, they mostly agree that the industry must evolve from its traditional ways to stay relevant to malleable market conditions.
Wang Hua (Sinovation): VC used to be just a minuscule part of the entire asset distribution engine, but today, it has taken center-stage. We cannot rely on traditional methods to manage increasingly complex asset capital.
Zheng Xuanle (Lighthouse): China’s current GDP per capita is only 1/6 that of the US. When it rises to 1/2 that of the US, and with our population of 1.4 billion, I believe there will be plenty of new value creation. Our job as VCs is to be the first to support them.
Zhou Wei (CCV): VCs used to be active in many places but now, the only viable markets are the US and China. This industry is only 50 years old, so I don’t think we should rest on our laurels. We must continually evolve to stay relevant.
Despite their advocacy for change, many China venture capital firms recognize that innovation within the industry itself will be long and difficult. It will require an overhaul of mindset and institutional transformation, but these are beginning to take root with on-going efforts aimed at re-inventing the VC engine.
Wang Hua (Sinovation): For innovation, we have created an engineering institute and an incubator. We are also supplying technical teams for the companies that we invest in.
Hu Boyu (XVC): We are systemizing our post-funding products and services. This year, we have procured over 40 top management roles for the companies that we invest in. We are also providing guidance on securing funds and financial planning.
Peng Chuang (Seas): We have set up a core “center stage” system to support our frontline team’s productivity. We will also systemize our standard services and create differentiated post-funding services. We also have plans for a talent grooming system.
Zhou Wei (CCV): We want our young team to lead projects instead of just executing. If you’re a fund manager with deep industry knowledge and a clear investment direction, you can lead.
The following investors are quoted in this article:
Chen Yuetian: Sea of Stars Capital, Partner (S. Capital)
Foo Jixun: GGV Capital, Managing Partner (GGV)
Gan Jianping: INCE Capital, Founding Partner (INCE)
Hu Boyu: XVC, Founding Partner (XVC)
Li Feng: Frees Fund, Founding Partner (FF)
Niu Kuiguang: IDG Capital, Partner (IDG)
Peng Chuang: Seas Capital, Managing Partner (Seas)
Wang Hua: Sinovation Ventures, Co-CEO & Managing Partner (Sinovation)
Xiong Fei: Matrix Partners China, Partner (Matrix)
Zhang Jinjian: Vitalbridge Capital, Founder & Partner (Vitalbridge)
Zheng Xuanle: Lighthouse Capital, CEO (Lighthouse)
Zhou Wei: China Creation Ventures, Founder & Managing Partner (CCV)
This story first appeared in 36Kr, the parent company of KrASIA.