Trends: Tapping the opportunities offered by China unicorns

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on July 23, 2018 - July 29, 2018.
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Although Silicon Valley has been a dominant force in the technology innovation and venture capital (VC) space, China is quickly catching up and its exponential growth is presenting investment opportunities. Nevertheless, it may be difficult for foreign investors to access this sector directly, say academics at INSEAD.

According to Claudia Zeisberger, professor and academic director at the school’s Global Private Equity Initiative, the start-up deal environment in China is very domestic and relationship-driven. “VC is by its nature a very local business. VC partners have always preferred to keep their companies close by. It is a high-touch business, hence proximity matters,” she says.

“Access is not easy, but joining an angel investing network is usually a good first step to establish whether the high-risk nature of early-stage venture capital investing matches the risk appetite of the high-net-worth individuals (HNWIs).”

However, there are easier entry points for indirect investments. HNWIs can invest in Chinese technology stocks, pre-initial public offering (IPO) allocations or funds of funds that have access to VC funds in China. One such fund — the CRCM Opportunity Fund, managed by ChinaRock Capital Management Ltd — has been able to reward the investors of the five-year-old private VC fund with 27 times its initial outlay after scoring huge returns from financing start-ups involved in artificial intelligence and ride sharing, among others.

Although most of the VC investments made in China today are domestic, foreign VCs have played a significant role in growing Chinese unicorns (defined as companies valued at more than US$1 billion), says Ian Potter, a distinguished fellow at INSEAD. The first wave — comprising the likes of Sequoia and Golden Gate Ventures, which have set up shop in China — not only brought best-in-class practices but also showed that there was money to be made by investing in very local ideas, he adds.

However, that seems to be changing. “Foreign capital has become less important recently with more local general partners investing successfully. Some of the partners of the [current] China VC firms are ‘sea turtles’ [Chinese slang for students who come back to the country after studying abroad] or those who had previously worked at foreign VC funds and have started their own vehicles. Local vehicles will clearly be the trend going forward,” says Potter.

 

A huge market

VC investments in China are huge. In fact, they could exceed those in the US over the next three years. According to “The Rise of the China Phoenix” report, published by INSEAD on May 2, if the growth in China is sustainable, it will quickly eclipse Silicon Valley as the world’s leading VC and innovation hub.

This will be driven by a number of dramatic reforms that the Chinese government has implemented to increase the competitiveness of its economy, says the report. First are the reforms in the capital markets, where regulators announced in March that they would fast-track the listing of unicorn companies. The country’s leading battery maker, Contemporary Amperex Technology Co Ltd, recently broke the record for the fastest A-share IPO approval — just 24 days compared with the average of three years.

There has been a record number of renminbi-denominated funds investing in China VCs. They are largely driven by state-owned entities with their own investment targets. They include the RMB350 billion sought by the China Structural Reform Fund, the RMB200 billion targeted by the state-owned Capital Venture Investment Fund and the proposed RMB150 billion for the state-owned Enterprise National Innovation Fund.

RMB funds are also started by VC funds of funds and wealth management firms run by HNWIs, offering them a viable alternative to traditional real estate and stock market investments.

According to the report, payment technologies and other financial technology innovations developed by Chinese companies may quickly leapfrog their Western counterparts due to the sheer size of the China market and much faster adoption. “China Phoenixes” — defined as start-ups with valuations of more than US$10 billion — were able to achieve valuations that were 32% higher on average than the largest unicorns in the US over a shorter period, or almost 60% faster than their US counterparts. The top US unicorns are worth US$28.6 billion and are 10.1 years old on average while China Phoenixes are worth US$34.5 billion and are six years old on average.

One example of a China Phoenix is Ant Financial, formerly known as Alipay. The valuation of the company is currently at US$100 billion to US$150 billion, just two years after its last fundraising that valued the company at US$60 billion to US$75 billion. According to the report, at just four years old, the private company’s valuation has already exceeded the market capitalisation of investment banking giants such as Goldman Sachs and Morgan Stanley.

Zeisberger says the Chinese have been investing in the upgrading of its technology across the board and have deployed substantial government and corporate resources to that end. These investments have accelerated in the last decade and are now showing results.

“The IPO of Alibaba in 2014 was simply the arrival of one mature unicorn (born in 1999) on the Western radar. Although it did take 15 years for it to mature and scale, it may have been a surprise to the West that the Chinese start-ups could go from captivity (domestic market) to the wild (global),” she says.

Apart from the unicorns, however, it is hard to say whether the smaller high-growth companies are getting sufficient attention and funding from VCs and angel investors. “There is certainly plenty of money sloshing around, and not only in VC funds. According to our last count, China has more than 450 incubators across the country. Some are government funded, some are funded with private money and some are supported by large corporates,” says Zeisberger.

“In general, VC funds focus on distinct stages of development in their start-ups. So, the VCs interested in later-stage [potential unicorns] will not write seed-stage cheques. Nevertheless, it is vital to have a complete ecosystem that offers entrepreneurs access to capital at every stage of the companies’ development.”

According to a joint report by a unit of China’s Ministry of Science and Technology and consulting firm Great Wall Strategy Consultants released in March, China had 164 unicorns worth some US$628.4 billion. This number is expected to grow, which means the future of VC investments is still bright.