Regulatory Upheaval in China’s Internet Sector
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China is turning up the regulatory heat on its once freewheeling internet sector, and private equity will help companies stay on the right side of change
For two decades, China's internet sector was allowed to innovate and flourish with relatively little interference from regulators. But times have changed, and Beijing’s priorities have shifted. The abrupt suspension of fintech leader Ant Group’s IPO last year sent a strong signal to China’s tech champions that their economic power no longer buys them special treatment. We are entering a period of major upheaval as Beijing reshapes its relationship with its tech giants and normalizes tighter regulations. A deep understanding of China’s regulatory system is a strong advantage in such a competitive landscape, and this is here private equity & venture capital (PEVC) partners can make a difference.
It is no secret that the runaway success of China’s internet sector in the 2010s was supported, to a fair degree, by a loose regulatory environment. Platform businesses like Alibaba and Tencent are a major source of pride, job creation, and tax revenue for the state. Even when these companies were found to have engaged in illegal activities, they never faced severe consequences. Alibaba, for instance, used to force merchants to sell exclusively on its platform in a practice known as ‘er xuan yi’, or ‘choose one out of two,’ during holiday promotion seasons. Sellers who also use rival platforms would be punished with less traffic to their online shops on Alibaba.
China’s tech giants have swiftly penetrated all aspects of the digital economy, from payments to credit scoring, often deploying aggressive tactics to build up their captive user ecosystems, eliciting anti-monopoly concerns in China. Questions have also been raised over who owns the consumer data these companies have amassed, and how it should be used. Like their US counterparts, Alibaba, Tencent, Pinduoduo, ByteDance, and Meituan control reams of consumer data. But, unlike Google or Facebook, they have used this data to significantly extend territory far beyond their core business, establishing massive consumer financing businesses, such as Ant Financial, and powerful investment arms. Tencent Investment, for example, has invested in more than 800 companies in more than 10 years, according to its website, and earned a stunning $120bn from stakes in more than 100 listed companies, 20x its net profit in 2020.
Regulation Normalization
As the negative effects of monopolies on consumers and competitors have become better understood, calls for greater regulatory scrutiny have grown louder. Shortly after the Ant fiasco last November, China’s regulators issued new anti-monopoly rules targeting platform companies and launched retrospective probes into their abuses of market dominance. On 10 April, Alibaba formally terminated forced exclusivity and other practices after it was fined $2.8bn by the State Administration for Market Regulation for abusing its dominant market position. On 13 April, China ordered all platform businesses to rectify their antitrust violations and other illegal activities within the next month, or face severe punishment.
These measures represent the first major steps by China to rein in its tech giants, but are not in any way unusual – Beijing is simply normalizing its regulation to world standards by removing the privileges it had previously conferred on its tech champions, and putting them back on an equal position with any other company in China. Yangtze River Pharmaceutical Group for example was fined $117mn for monopolistic practices. Those who believe that China’s internet companies are being unfairly targeted have failed to recognize this. Governments worldwide are studying how to curb the monopolistic power of big tech, and China is just catching up to that trend. Like the European Union, China also wants to keep a closer eye on how companies use big data. On 5 March, Beijing called on its tech giants to open up data in areas from e-commerce to social media to promote healthy development of the sharing and online economies.
Lina Khan, the newly appointed commissioner at the US Federal Trade Commission, once authored a legal paper on how antitrust law could be used to prevent Amazon from extending its dominance to new businesses. Her research has helped to trigger a new approach to antitrust issues in the US, and China will borrow from existing frameworks in both the US and EU to lay down new rules on data management and usage to curtail dominant tech companies from extending their influence too far beyond their core businesses.
Mitigating Regulatory Risks
It is too early to tell what the final scope of China’s antitrust and big data regulations might entail, or which companies might fall under their purview. China wants to be a world leader in artificial intelligence, and will have to work with its tech champions to achieve this. That said, mitigating regulatory risks is not as burdensome as it seems.
Fundamentally, China wants its tech companies to be responsible corporate citizens. In the US, public watchdogs and the free press constantly pressure US companies to be socially responsible. Such a supervision mechanism is absent in China, so the Chinese Government takes on that role. In fact, Beijing’s priorities dovetail nicely with the prevailing movement to integrate environmental, social, and corporate governance (ESG) considerations into investment decisions. Strong corporate governance not only ensures the sustainability of a business, but is frequently also a source of competitive advantage.
PEVC firms play an important role in guiding investee companies’ approach to corporate governance, and they must hold investees to higher standards going forward. It is widely known that many Chinese crossborder e-commerce companies that sell consumer goods overseas are routine tax-evaders who fail to comply with foreign reserve regulations. But this did not stop PEVC investors from pouring money into these companies last year. In China, thus far, ESG due diligence assessments haven’t always been a dealbreaker for PEVC firms. This has to change. Staying within the law should be a fundamental tenet of running any business. PEVC firms need to insist that internal risk management and checks and controls are enforced.
Astute PEVC firms should also take the lead in helping investees set up a direct communications channel with regulators, to enable them to proactively engage regulators and cultivate a good working relationship with them. To do that, PEVC firms will first have to study and understand the intricacies of China’s complex regulatory system, and build a network that can help them anticipate and stay ahead of the changes that are on the horizon. Adopting a positive, cooperative attitude is the best way to eliminate regulatory risks.
PAC’s deep understanding of China’s regulatory system and government operations is based on our previous professional experience and connections with regulators established more than a decade ago. Our investee companies are always encouraged to proactively speak with their respective regulators to build mutual trust and understanding. US-listed Tiger Securities for example keeps local regulators updated about its latest business development on a monthly basis, and has won the regulators’ confidence. TalkingData, China’s Palantir, has kept a very close relationship with the Ministry of Industry and Information Technology for many years and was the only private company invited to participate in the establishment of China’s big data industry association. Ultimately, companies that thrive in China are those that have earned the blessing of regulators.