Spread across roadsides the length and breadth of the country, red banners with the ubiquitous phrase ‘Party Spirit’ extol the virtues of the Chinese Communist Party (CCP). The term has become a catch-all to describe behaviours the Party considers correct and worth promoting. Most of them are fairly prosaic, for example praising filial piety. But with the economy straining under the weight of zero Covid and global inflation, the Party is starting to liven things up. It’s time to break the mould and harness the ‘animal spirits’ of venture capitalism. 

Chinese policymakers need to give the country’s private capital markets a bit of a kick because confidence is waning. In Q1 of this year, early-stage investment by venture capitalists declined by 90% year on year. Then there is the issue of ensuring that investment gets directed to where the Party wants money to be spent, preventing the “disorderly expansion of capital,” otherwise known as the platform economy growing out of control. Trillions of RMB of government funding is now pumping through China’s private capital markets, with mixed results for the country’s entrepreneurs. 

Background 

There is a new sheriff in town, and China’s private sector has had a rather rude awakening to this fact over the past two and a half years. The State Administration for Market Regulation’s (SAMR) decision to slap a record-breaking £2 billion fine on Alibaba in April 2021, in response to founder Jack Ma’s infamous speech in October 2020 criticising the government’s handling of China’s financial development, was the turning point. From then on, no entrepreneur, service, or technology could be perceived as equal to or above the government or its regulators. It has brought substantial change: consumer-internet technologies are out, replaced by artificial intelligence, biotechnologies, and advanced manufacturing. 

In short, the Chinese government is reshaping one of the world’s biggest start-up scenes — and perhaps not necessarily for the better.

What are government guidance funds?

Government funding now accounts for around 30% of private equity and venture capital funds raised in China. Between 2015 and 2021, around 2,000 “government guidance funds” were collectively responsible for almost £850 billion. Government guidance funds are public-private investment funds that aim to simultaneously produce financial returns and further the government’s industrial policy goals. Research shows that Chinese officials have set up around 1,800 guidance funds, through which the government hopes to raise as much as £1.3 trillion, although it appears that investment peaked in 2016 and the government will fall far short of that number this year. 

No matter though, as that is still potentially a very hefty war chest. Besides, it is more than enough to entrench the government as the country’s primary source of venture capital and private equity — incentivising entrepreneurs to innovate as Beijing sees fit. 

Will increased state involvement in venture capital work? 

Yes, or at least in theory. Combining patient capital from the state with the market savviness of private investors should give the Chinese government the best of both worlds while avoiding the pitfalls of conventional industrial policy along the way. 

The problem lies in the government’s willingness to let the private sector do what the private sector does, and its risk tolerance. Should the government feel that the private sector at large is not playing ball, it could be tempting simply to back a smaller pool of companies, and then these funds would turn into just another state subsidy or resemble old-school support such as state-owned enterprises (SOEs) used to enjoy. 

So far, at least, it seems that the majority of such funds have registered that, while they want to do right by their benefactor (the government), it is also possible to have too much of a good thing. Many funds have rules dictating the maximum amount one single partner can invest, usually around 25% of the total. 

Guidance funds are structured differently from conventional venture capital or buy-out funds, where the originator acts as the general partner tasked with deploying the capital. A guidance fund, by contrast, often creates sub-funds in which it is a limited partner and it invites professional asset managers to be the general partner calling the shots. 

The result is that the government can only be another limited partner and cannot decide unilaterally where the money goes, or at least that is the theory. However, there is the possibility that SOEs or other government-linked entities could collaborate with the government as additional limited partners and push investment where the government wants it to go. 

Finally, with so much government money readily available, it not only leaves private investors – that typically have more demanding lending terms – out to dry, but also risks widespread inflation of company valuations: as it becomes easier to secure government funding, companies might begin to give themselves higher valuations. It seems it might be far from a perfect solution.

The CBBC view 

Government guidance funds are an interesting idea with the potential to work well. However, they represent a powerful incentive for entrepreneurs to focus on being close to the government first and being innovative second. Depending on their management, guidance funds could quickly turn into another form of state subsidy, where only companies focused on the technologies the government wants to pursue see any investment. And while that might be an effective way of creating a cohort of competing average smartphone manufacturers, for example, it is not necessarily a recipe for technological progress: each company may do just as much or as little as the others to ensure it continues to receive funding. The Chinese technology sector behaved in such a way in the early 2010s, but those days feel long gone now – remember Meizu phones, anyone? 

To make government guidance funds a success, it seems that it will have to trust the animal spirits of the country’s venture capitalists far more than it has indicated it would be willing to do to date. Harnessing them too tightly could be a grave mistake.

Call +44 (0)20 7802 2000 or email enquiries@cbbc.org now to find out how CBBC’s market research services can help you build knowledge and understanding of the Chinese market prior to investment.

The post Government Guidance Funds: Venture Capital with Chinese Characteristics appeared first on Focus - China Britain Business Council.

According to figures released by business information service provider IT Juzi, startups in China attracted RMB 354 billion (approximately £39.2 billion) of investment in the first quarter of 2021. As the Chinese economy rebounds post-pandemic, the number of venture deals in China increased for the fourth consecutive quarter, rising by 56% in Q1 2021.

As an example of the scale and pace of recent investments, according to the China Money Podcast, 73 deals were closed in the week ending 11 June 2021, totalling almost $4 billion (£2.8 billion).

This increased venture capital flow comes after a two-year period when many Chinese startups struggled to raise money. It also goes hand-in-hand with a so-called “startup boom” in the US, where analysts have been surprised to see high-propensity business applications reaching their highest quarterly level on record even amid the pandemic and a deep recession.

China’s top investor in Q1 2021 was Tencent, which made 82 investments in sectors including gaming, corporate services and education. Sequoia Capital China made 55 investments during the same period. The sector with the most active investments was biopharmaceuticals (128 deals), followed by integrated circuits, medical devices, and food and drink. This fits with wider trends that suggest physical technology and consumer products and services still attract the most VC funding in China, as opposed to software as a service (SAAS) companies in the US.

Outward investment from China is also increasing, especially in Southeast Asian markets. In early June 2021, $10 billion (£7.1 billion) was added to the qualified domestic institutional investor (QDII) scheme. The QDII allows investors in China to invest in overseas securities and bonds via certain approved financial institutions. The QDII has accumulated a total of $147 billion (£104.4 billion) approvals since it was launched in 2006. The latest increase in QDII outflows is thought to be part of moves to allow more capital to leave the country to counter the rising renminbi, which hit a three-year high against the dollar in May.

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In the first half of 2018, Chinese outbound foreign direct investment (OFDI) has dramatically veered towards Europe over North America. The value of completed Chinese investments was six times higher in Europe (£9.3 billion total with £1.25 billion in the UK) than in North America (£1.55 billion), according to    Baker McKenzie and Rhodium Group. This trend looks set to continue, with technology firms in particular considered the “crown jewel” of Britain for Chinese investors. According to Management Consultancy Firm Mckinsey, China’s outbound investment will resume its upward trajectory with a focus on “Made In China 2025” sectors and digital technology, areas such as Artificial Intelligence (AI) and the Internet of Things (IoT).

We find that UK SMEs are particularly attractive for Chinese institutional investors, due to the strength of “Brand Britain” and the UK’s status as a world leader in innovation

This upwards investment trend is partly due to China’s fluctuating stock market and lower real estate returns at home. China now has the second-highest number of billionaires globally and many of these are diversifying their investment portfolios to include UK assets, which are perceived to be more stable.

Investment firms, such as the newly established China Heritage, where I serve as Chief Marketing Officer, are responding to this need by helping private investors diversify their portfolio abroad. We find that UK SMEs are particularly attractive for Chinese institutional investors, due to the strength of “Brand Britain” and the UK’s status as a world leader in innovation. Due to the potential for a post-Brexit UK-China trade deal and the rocky China-US trade relationship, there has never been a more encouraging outlook for UK SMEs to raise Chinese funding.

“Along with capital, Chinese investors can provide important market knowledge and distribution capabilities, while the sheer size of the market enables companies to test and refine products with condensed timescales,” says Mark Hedley, technology lead at the China Britain Business Council.

Types of Investors and How to Reach Them

Angel Investors and High Net Worth Individual (HNWI)

Angel investors typically provide seed funding through a one-time investment or an ongoing injection of funds to industries which they understand and where they can offer value. The best way to find angel investors is by reaching out to your network and their peripheral relationships in the same industry or a complimentary line of business.

Family Offices

A single family office (SFO) is a private company that manages investments and trusts for a single family. Much of their wealth is in its first or second generation, so many families are still aggressively seeking greater returns instead of wealth preservation. SFOs are particularly common in China and many can be found through professional wealth management firms in Hong Kong and Singapore.

Government Grants and Funding

Both the UK and Chinese government routinely offer grants and funding to collaborative projects. In 2015, both governments collaborated on a £16 million fund for joint projects in energy, healthcare, urbanisation and agri-food. At Kaitlin Zhang Branding, we have helped UK clean tech firm Loowatt raise RMB 1 million (£110,000) joint funding from the Guangdong Provincial Department of Science and Technology. Keep an eye out on government websites for these opportunities.

Venture Capital (VC) Firms

While Chinese venture capital firms don’t often disclose financial information, there was a considerable uptick in financing activity during 2017, with total annual Asia funding activity increasing by 117 percent year on year, according to CNBC.

“A venture capitalist looks for a strong product or service that holds strong competitive advantage, a talented management team and a wide potential market,” according to Will Jiang, Partner at N5Capital, a Beijing VC firm and previous client of Kaitlin Zhang Branding.

Firms that are looking to establish their brand in China are particularly attractive to VCs because they like to lend their expertise to help their portfolio companies succeed through activities such as marketing and recruitment. The key to finding the right venture capital firm is by researching the firms that typically invest in your geographic location, funding series and industry. Websites such as Crunchbase and 36kr can help identify suitable firms.

Kaitlin Zhang is the CEO of Kaitlin Zhang Branding, a cross-border digital marketing agency specialising in technology and financial services. The company works with UK technology firms to establish their brands in China and support them with raising vital capital. The company also works with some of the top Chinese venture capital firms and private investors to build their brands outside of China, in addition to supporting fundraising efforts in excess of $200m USD.  

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