I’ve been following the China tech industry on and off for almost ten years. In that time, I’ve seen quite a few booms and busts, but surprisingly, the conversation follows a clear pattern:
- First, people start asking if this is a bubble. While the question nearly always answers itself (yes), VCs and entrepreneurs are wary of answering directly. Instead of “bubble,” they’ll use words like “frothy” or “dynamic.”
- Next, when it’s clear that the bubble is about to pop (or already has), everyone starts talking about a “capital winter,” a very apt metaphor that quickly becomes a cliche. Money, like water, becomes “frozen” and weak startups begin to die.
- Finally, once the macroeconomics stars realign, the entire cycle begins again—with nothing really learned except the old adages of “make hay while the sun shines,” “it’s not that bad,” and “fail fast.”
Looking at this phenomenon, I was struck by how little the public is aware of where VCs themselves get money. Who exactly is funding the funders? What impact do they have on startups?
Bottom line: After 15 years of rapid growth, government money (usually in the form of guidance funds) is drying up and VC firms themselves are finding it harder to close new funds. State-backed guidance funds are becoming pickier about who they work with, while non-government backers are also concerned more with cash flow and less with rate of return.
VCs in China have at most eight years to show returns to their own backers (compared to their US counterparts, who have up to 12 years) and sometimes as few as three. Until recently, RMB funds were preferred by VCs because the backers were less demanding. However, VCs are increasingly looking towards USD backers to keep the lights on. As the market for backing VCs matures—and growth slows—so too will the startups receiving funding.
How VC funding works: Venture capital funds are just another asset class. However, since they operate with risky investments, the total return on investment can be significantly higher than other asset classes like stocks, bonds, and other securities. Typical return rates in China are between 5-14%, but some general partners boast up to a 20% rate of return—a claim met by skepticism by TechNode staff.
From the top down
- Institutional investors and wealthy private individuals need to keep their money working. Government guidance funds, however, are more about making sure investment-led economic growth follows policy priorities or benefits their locality (city, county, province, etc).
- Venture capital firms raise money from institutional investors, wealthy individuals, and guidance funds to invest in startups they believe will provide a successful “exit” (IPO, acquisition, or even equity sale during subsequent funding rounds).
- Startups require money to fuel growth models that put speed over profit.
The role of guidance funds: Since reform and opening-up under Deng Xiaoping, China has transformed from a command economy into a market economy. The government, however, still retains its position as leader. Through policy documents, regulations, meetings, and speeches, the central government sets the priorities. Local governments scramble to figure out what the real priorities are and then how to show results to their bosses.
While the first guidance funds began appearing in 2002, it wasn’t until 2008 that the National Development and Reform Commission created a definition:
“[Guidance funds are] a type of policy fund that is established by the government and managed in market-oriented fashion with the aim of … attracting more capital investment in startups.”
Guidance funds, however, are not meant to invest directly in startups. Instead, they provide partial funding to venture capital firms and other funds with the rest of the total formed by “social capital,” i.e. private money.
According to research done by TechNode’s Financial Advisory team, most guidance funds have a broad mandate to either increase GDP in their local area or focus on specific verticals (AI, e-commerce, manufacturing, etc).
Guiding numbers: According to a December 2018 report by Chinaventure (in Chinese):
- 93.33% of guidance funds are interested in medical treatment, health, or TMT (telecommunications, media, and technology). TMT, in China, covers most of tech.
- 90% want to be on the decision-making committee of their invested sub-funds.
- More than 70% want to work with firms with at least three years of successful exits.
- More than 90% have clear minimum requirements for key people in sub-funds.
- Guidance funds usually provide 15-30% of total sub-fund funding.
- 30% have considered creating funds with overseas LPs and GPs.
- Estimated return rate in 2018 was 10-15%.
Inefficient guidance: Another report, by Qingke Private Equity (in Chinese), found some major problems with how guidance funds operate:
- Since 2008, only 882 out of 2,065 guidance funds have made investments, leaving 57% of aggregate funding still available.
- By the end of 2015, 30% of the RMB 109 billion in central government-backed guidance funds had not been used.
- A random survey of six local guidance funds found that 66% of their RMB 18.75 billion had been deposited in savings accounts.
- 73.51% of all money from guidance funds winds up in companies that are either expanding rapidly or are already mature.
- Only 6.41% of the money is invested in seed stage companies.
RMB drying up: From 2002 to 2016, over 2,000 guidance funds were created. In 2016, guidance fund growth peaked at 572 new funds. In 2017, the number of new funds was only 284. By December 2018, only 264 new funds were created.
Data from Preqin, a financial data provider, shows that the number of VC funds closed peaked in 2015, but aggregate capital raised peaked in 2016. According to our Financial Advisory team, over the last six months, more and more China-focused VCs are seeking overseas LPs, who provide US dollars. While they are usually more demanding and focus on rate of return, the RMB is weakening and the “innovation” sector is seeing less and less support from the government.
Slowing China speed: As TechNode contributors have previously reported, opportunities in the consumer space for companies both large and small are quickly diminishing. Not only is easy growth from demographic and mobile dividends rapidly drying up, but the total amount of money available to fund startups—whether 2C or 2B, digital or physical—is also slowly decreasing. This means boom-bust cycles will be increasingly infrequent while VCs become pickier to hedge their bets. Instead of getting easy money on inflated valuations, founders must start thinking about creating sustainable (or kind of sustainable) businesses.
From our perspective at TechNode, this is a good thing. Rapid growth also means rapid social change. The trade-offs inherent in technology adoption (convenience vs. privacy, for example) often go unquestioned as people race to a “better life.” Slowing startup growth could also mean fewer externalized costs—such as having bikes moved to designated zones by security guards of property management companies instead of bike rental employees—and less value destruction in the form of broken bikes, empty office buildings, and scam artists.
The VC model of economic growth is great for many reasons, but in the last few decades, with the rise of consumer technology, it has gotten out of hand. I, for one, am glad things are slowing down and founders can get back to doing what they should be: creating sustainable businesses that benefit their community and broader society.