Investment: trend for ‘de-risking’ hits venture capital in China

Stephen Mulrenan, IBA Asia CorrespondentMonday 7 August 2023

The term ‘de-risk’, meaning to reduce economic vulnerability to a country without damaging trade or investment, was first used in the context of China by European Commission President Ursula von der Leyen in March. But Chinese Premier Li Qiang told a World Economic Forum meeting in Tianjin that it wasn’t for governments to decide, adding that businesses are in the best position to assess risks.

One business that has, seemingly, made that choice is US venture capital (VC) company Sequoia Capital, which announced plans in early June to split off its Chinese and Indian/Southeast Asian operations into two independent companies. Sequoia is known for its early investments in US tech companies such as Airbnb and Apple, and it has also played a prominent role in the rapid rise of Chinese tech giants such as Alibaba and ByteDance since entering the country in 2005.

In a letter to limited partners, Sequoia confirmed that the split would happen ‘no later than’ March 2024. The company’s leadership offered four main reasons for the move. Firstly, conflict between the funds’ respective start-up portfolios; brand confusion as each regional fund diverged in strategy; the increasing complexity of maintaining centralised regulatory compliance; and an acknowledgement of the frostier geopolitical environment, which is making life harder for US VC funds investing in China. Weiheng Chen, Senior Partner and Head of the Greater China Practice at Wilson Sonsini in Hong Kong, believes concerns about portfolio conflict and the complications and costs of maintaining global compliance functions in the evolving geopolitical environment may have contributed to the decision.

According to recent reports, many dollar and yuan investors had concerns about investing in Sequoia China under the global brand amid China–US tensions. Sequoia Capital didn’t respond to Global Insight’s requests for comment, but Roelof Botha, Managing Partner of Sequoia Capital, has stated that ‘Over the years, we have reassessed the cost-benefit trade-off of this arrangement and whether it was the right structure for the firm. We realised it was time for [the splitting of the business]’.

The fundamental issue is the lack of investor confidence due to the combination of concerns over economic recovery and market overhang of geopolitical uncertainties

Weiheng Chen
Senior Partner and Head of Greater China Practice, Wilson Sonsini

Chen says that Sequoia China and Sequoia US have always been separate funds with separate limited partner (LP) bases. He explains that some of the LPs may be overlapping, but investors are ‘pretty clear’ that if they want more China exposure, they need to invest in the China company, and if they don’t, they can just invest in the US company.

Ramesh Vaidyanathan, Co-Chair of the Asia Pacific Regional Forum and a partner at Advaya Legal in Mumbai, says the bottom-line separation, where there’s no longer any pooling of profits, is a very clear message from Sequoia, specifically: ‘we want to keep out of what may be considered tricky jurisdictions’.

China-focused VC fundraising is heading for its weakest first half year in at least eight years, according to data from researcher Preqin. The feeling is that economic challenges and geopolitical tensions have made investment in China difficult – and have eaten into global VC funds’ returns.

Sequoia China’s most recent fund was a huge success, raising $9bn of mostly foreign money in 2022. However, more recently it has prioritised non-tech investments, including in infrastructure, as well as its hedge fund public equities practice. China’s economic recovery post-Covid has also fallen short of analysts’ projections. The reason for the slowdown, says Chen, is due to market sentiment. ‘The fundamental issue is the lack of investor confidence due to the combination of concerns over economic recovery and market overhang of geopolitical uncertainties’, he says. ‘This casts a huge shadow in the near- to medium-term in the VC and growth equity market and negatively affects fundraising activities.’ Caroline Berube, Co-Chair of the IBA China Working Group and Managing Partner of HJM Asia Law & Co in Guangzhou, adds that ‘There has been a recent trend of individual investors “dumping” their China shares, resulting in sizable devaluing of stocks on the China markets’.

Vaidyanathan says the prospect of a strategic US outbound investment review programme launching later in 2023 is a key factor. ‘There’s a lot of political scrutiny in the US for investments in Chinese companies because there’s a perception in Washington, DC, of [such companies presenting a] national security risk’, he says.

The US Committee on Foreign Investment in the United States (CFIUS) has authority to review the national security implications associated with certain foreign investments in US business, or the acquisitions made by US companies. In contrast, a ‘reverse CFIUS’ mechanism would enable the US government to screen and monitor outbound investment from the US to ‘countries of concern’. President Joe Biden’s administration has been working on various programmes to restrict the flow of US dollars into China, explains Vaidyanathan. For example, in the last couple of years the US has placed various Chinese companies on an investment exclusion list, banning US citizens from buying and selling shares in them. ‘The US sees it as a way to hobble China when it comes to the development of technologies that are crucial to national security, such as artificial intelligence, quantum computing, and semiconductors’, he says.

Many law firms now have devoted foreign direct investment/national security teams to assist organisations in complying with the wide range of national security restrictions and consents required to close a deal, says Berube. ‘And this is only expected to grow with the ongoing heightened national security restrictions being placed on certain investments in certain sectors not only in China but worldwide’, she adds.

However, with a number of top-league, cash-ample funds reportedly keen to deploy the dry powder they sat on throughout the pandemic, there’s hope that VC investment in China could pick up later in 2023. ‘Many VC investments are interested in tapping into the big Chinese consumer market and [the country’s] growing middle class’, says Berube. ‘For example, there has recently been increased VC investment in the electric vehicle/green sectors.’

While there has been a recent improvement in the volume of buy-out deals, Chen says there needs to be a meaningful rebound in the underlying economy for VC deals to really pick up. ‘And investors need to grow back more confidence for the overall China growth story and the exit viability before we see a pickup in those earlier stage deals, where you need at least a three to five-year investment horizon’, he adds.

Vaidyanathan says that money will still get deployed in China. ‘China has produced decent returns for some of these funds, so I don’t see that money being diverted elsewhere’, he explains. ‘But the level of enthusiasm that was probably available a few years back may have waned a little.’

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