What Venture Investors Get Wrong About China
Original Article Published on The Information
The Takeaway: Investors don’t pay adequate attention to how the Chinese government crafts policy, leaving them blindsided when the rules change.
For two decades, investors in China’s venture capital firms have looked for partners with an instinct for the “new economy.” And for two decades, the firms have posted high-flying returns primarily driven by winners in this fiercely competitive arena—including upstarts in budget appliances (Xiaomi), social media (ByteDance), ride hailing (Didi) and food delivery (Meituan)—that seemed to validate that approach. Not anymore.
China’s capital markets in 2021 will be remembered for their plummeting tech stocks—triggered by sweeping regulatory moves from Beijing, escalated by a cybersecurity investigation into Didi launched mere days after the ride-hailing giant’s U.S. initial public offering, and brought to a head by the complete overhaul of the commercial tutoring sector.
As investors and asset allocators scrambled to make sense of the abrupt changes, even those in China were left in a daze, deliberating over the same questions: Why regulate now? What will happen next? How do we proceed? Lacking clear answers from the general partners at their venture firms, many limited partners are now asking themselves yet another question: What does it mean to really understand China?
In the U.S., Silicon Valley powerhouses operate within the framework of the U.S. legal system, and while this involves navigating many contingencies and contradictions, they understand the underlying structure of policy and regulation at the national and state levels. Most venture capitalists don’t realize how deeply embedded this capability is in their decision making, and how much of this influences their foreign investments.
While the China branches of U.S. firms and homegrown funds inherited this legacy operating model, they have seldom built up a comparable depth of awareness of policy and regulation in China. There are two reasons for this:
The tech sector has long been isolated from the rest of China’s economy. Western-educated Chinese professionals manage Cayman Islands-domiciled funds, denominated in U.S. dollars. Those funds invest in private Chinese tech companies that are also Cayman registered. When those companies go public via Nasdaq or the New York Stock Exchange, overseas limited partners get their exit. While the Chinese government has consistently hounded other industries such as real estate, the tech sector has largely remained unscathed. This was because:
For a long time Beijing prioritized economic growth over compliance enforcement. Regrettably, tech companies and GPs alike took this laissez-faire attitude for granted, showing little if any interest in familiarizing themselves with regulatory standards and the policymaking process. Some fund managers don’t know what Fukai Tower is—the home of the China Securities Regulatory Commission, China’s Securities and Exchange Commission.
Eventually, complacency flared into distrust between regulators and GPs, and mutual isolation deteriorated into estrangement. Many VCs completely missed the signs that the Communist Party’s attitude was changing.
A number of American investors have consulted me about GPs who claim to understand China because of their connections with specific government officials. While these connections can yield useful information from time to time, they do not amount to a structural understanding of China’s strategic policymaking, regulations and functional jurisdictions.
To explain, I’ll use a metaphor: I frequently watch NBC’s “Today” show, which broadcasts from the iconic Studio 1A in Rockefeller Plaza. NBC producers know how the set is assembled and how broadcasts are delivered, but based on that alone they cannot claim to understand the architecture of the entire complex.
Analyzing companies purely through financial data, business models and industry development is like touring Studio 1A to understand Rockefeller Plaza. Likewise, relying on a few government officials may help VCs understand specific policies, but such insights—bound to industries, geographies and office terms—only provide a partial view of China.
Investors must also evaluate how policy and regulation will affect a company or sector’s underlying operations—an analytical process that will yield markedly different conclusions than one based on fundamentals alone.
To acquire a holistic view of China’s investment landscape, one must start at the macro level. Seven plenary sessions follow each Party Congress and Politburo meeting, where officials establish a unified vision for China’s core national interests. While that proceeds, the bureaucrats of the Central Financial and Economic Affairs Commission lead the design of policy directives to achieve that vision on a macro level. Then finally, at the micro level, various ministries are charged with formulating and implementing those policies.
Calibrating one’s mindset for navigating these macro-micro interactions is key to making both timely and well-informed investment decisions in China. We need look no further than the education technology fiasco to see the system in action.
Macro Level: In July 2020, the Politburo introduced the Inter-Cycle Policy, designed to address the systemic problems that had led to inequity in real estate, education and healthcare. At the Fifth Plenary Session of the 19th Party Congress Central Committee in October 2020, officials proposed the policy once again, emphasizing Beijing’s resolve heading into the 20th Party Congress this fall.
Micro Level: The proposed industry framework to decommercialize the after-school tutoring sector was directly linked to the prognosis that arose from the Fifth Plenary Session. Soon after that session, the Ministry of Education began formulating new policies, and by the first quarter of 2021, working drafts began to circulate to ed tech companies and industry advisers. After seeing one draft, my firm, Prospect Avenue Capital, promptly terminated the two ed tech investments we had been actively considering.
Despite the warning signals, many investors had no idea this policy was in the works and continued to pour hundreds of millions into commercial tutoring, with the spending frenzy proliferating to more than $1 billion a month in marketing expenses alone. Investors with huge bets on ed tech—including Softbank’s Vision Fund, Tiger Global Management, KKR, Sequoia China, Hillhouse, Tencent and Alibaba—all saw their money evaporate overnight.
The formulation of new rules on overseas listing and an ongoing cybersecurity review have prompted some investors to more closely study the rollout of new policies. But even now, investors hunting for signals on the upcoming Party Congress are mostly focusing on the identity of key decision makers rather than adjusting their underlying structural thesis.
Truly staying ahead of the curve requires supplementing a basic structural perspective with comprehensive, holistic, nuanced policy expertise, refined through proprietary research from investment partners and direct engagements with policymakers. Any LPs still wondering how to identify the right Chinese GPs to approach should ask these questions: What is the purpose of each of the seven plenary sessions? Why does the Politburo always hold its meeting in the last week of April and July? What investment opportunities does Beijing outline in the 14th Five-Year Plan?