The Investment Case for China

We would be remiss to gloss over the dizzying climate surrounding China and its relations with the U.S. as we approach the investment case for allocating to the Chinese venture market. While the deepening tension has a somewhat mercurial nature, China’s role in the innovation economy is increasingly attractive, with factors at play like tightening U.S. immigration policy, a declining international student population in America post-COVID and re-localization trends amid a globally remote work environment. China’s native venture ecosystem has also achieved critical mass, catalyzed by social development, industrial upgrade, tech breakthroughs and business innovation, all of which are driving the country’s new economy. China is now one of the few venture markets that is large enough to be self-sufficient, with a government nearly unrivaled in its support of its domestic innovation economy, making it a fertile ground for value creation and an area of opportunity for venture investment.

In 1990, investment in Chinese companies represented less than 1% of the total capital deployed in the venture ecosystem.¹ By 2019, that number had ballooned to a whopping 30% share of the capital invested in venture globally.² These figures illuminate an obvious yet profound reality: venture capital is no longer a cottage industry relegated to the hallowed halls of Silicon Valley or other coastal U.S. cities. With launch costs radically declining and startup secrets increasingly available online, tech talent is becoming more broadly dispersed – and access to capital is following suit.

Globalization in venture capital is upon us and, amid a confluence of macro and industry-specific factors, we believe that China represents an obvious complement to the U.S. in the venture market. Further, we believe that an institutional investor’s venture program can no longer be complete without significant exposure to China. In the coming paragraphs, we will highlight the demographic and structural factors that underpin our conviction in this thesis, as well the country’s actions to recover following the COVID-19 pandemic.

Fundamentally, we believe three elements help determine the relative attractiveness of a certain venture capital market. These include:

        1. Market size & demographics
        2. Robust public market & acquirer set
        3. Government policy & culture

In China, the evidence suggests that strong tailwinds will position each of the three elements as highly favorable to the continued developments of its venture ecosystem.

Market Size & Demographics 

China’s demographics are staggering. China’s five largest cities are four times more populous than their U.S. counterparts. In fact, every single city in China’s top 15 is more populous than Los Angeles. The country’s total population has now reached approximately 1.4 billion, outnumbering U.S. citizens by four to one. Beyond the headline population numbers, we are struck by what we refer to as China’s “native ecosystem,” born out of a unique set of demographics during a period of strong economic growth. In the U.S., digital adoption can be described as relatively slow and incremental (think PC and dial-up Internet to laptops with Wi-Fi to full-scale mobile Internet ubiquity). In China, on the other hand, digital adoption was swift.

In 2010, when mobile Internet usage first went mainstream, there were over 242 million people in China between the ages of 15 and 24, as compared to about 44 million in the U.S. in the same year.³ Rather than swapping desktops for touch pads, Chinese consumers, especially those in the 15 to 24 age range, were first introduced to the Internet through mobile devices. Simultaneously, over the last ten years, China’s per capita GDP has risen 92%, giving rise to consumers and enterprises with meaningful purchasing power. Of equal importance going forward is the significant remaining potential growth that the country’s economic engine is poised to produce. Despite its current status as one of the preeminent global powerhouses, China is still exhibiting one of the highest economic growth rates of any nation. As a result of China’s size, in an absolute sense, its GDP added annually is roughly equivalent to the value of the entire Australian economy.⁴

As a result of these factors, the mobile centric companies built by Chinese entrepreneurs have and will continue to be able to scale in an unprecedented manner. As a market comparison in the chart below, we examined the largest companies in four major Internet verticals in the U.S. and China based on relevant user metrics.⁵ China’s largest payment company completes 24 times more daily transactions than its U.S. equivalent. China’s largest ecommerce company sells over 3 times more goods than its U.S. equivalent. China’s largest chat platform has 4 times more monthly active users than its U.S. equivalent. And, finally, China’s largest social media site has 6 times more monthly active users than its U.S. equivalent.

Potential market size in venture really matters. Its impact can be felt in several different ways. First, the largest companies in China can reach a scale that is challenging to achieve in smaller markets. As of the end of 2018, the average post-offer value of China’s five largest venture-backed companies to complete an IPO in the last five years was $31.6 billion.⁶ By contrast, the top five venture-backed U.S. IPOs had an average post-offer value of $8.0 billion.⁷ Not only do Chinese companies typically have the potential to reach a larger terminal value than those based in other countries, they tend to scale more quickly. A report from the South China Morning Post suggests that Chinese companies that reach the requisite scale to command a $1 billion valuation do so in roughly 4 years, while it takes U.S. companies approximately 7 years to reach the same valuation threshold.⁸

Robust Acquirer Set & Public Market

As of 2018, nine of the top 20 highest valued technology companies were based in China.⁹ All nine of these cracked the top 20 in the last five years. The current cohort, which includes companies like Alibaba, Tencent and Xiaomi, have all reached a size and scale where sustaining market share will require organic growth, as well as that obtained via acquisition. This leads us to believe that the Chinese tech giants will adopt a similar strategy to their US counterparts: acquiring venture-backed companies as a key engine for driving innovation and growth.

In addition to a growing set of potential acquirers, China has taken strides to create a more accessible public market for venture-backed companies. In mid-2019, China launched a new exchange board focused on innovative companies referred to as the Shanghai Stock Exchange Science and Technology Innovation Board, or the “STAR Market” for short. The board does not require companies to be profitable to apply and relaxes many restrictions common in other Chinese exchanges. Companies must simply register with the country’s securities regulator and undergo a financial and business audit. Investors generally agree that the new exchange will represent another viable liquidity option for Chinese companies, versus needing to access the public market solely in Hong Kong or the U.S.

Government Policy & Culture

Many view the American free market system, where entrepreneurship and risk-taking are celebrated, as the optimal environment for a healthy venture capital ecosystem. While this approach has certainly been effective in the U.S., we believe that multiple economic systems can create a thriving venture environment. China’s central government is certainly susceptible to criticism for human rights violations, censorship and lack of due process, among other issues; however, the evidence suggests that decisive action on its part has helped create a thriving venture capital ecosystem, spurring job creation and economic advancement.

A cornerstone of President Xi Jinping’s tenure is his ten-year strategic plan called “Made in China 2025.” The plan seeks to foster economic growth through technological advancement in areas like robotics, quantum computing and artificial intelligence to reach a position of global technological leadership by the year 2049. While there is some controversy regarding the plan due to claims of intellectual property theft, it has been a major catalyst spurring technological innovation. As part of the program, sources cite that China’s central government is committed to investing at least $300 billion into the startup ecosystem during the course of the ten-year plan.¹⁰ This level of investment, coupled with subsidies, infrastructure improvements and deregulation, has spawned a sustained healthy environment for venture capital.

COVID-19 Recovery & Long-Term Impact

As the first country to face the devastating impact of COVID-19, the spotlight has been on China's ability to navigate the recovery process and analyze which industries best weather the economic fallout. Not surprisingly, the pandemic’s impact on the economy at large was swift and harsh. For the first time since the 1970s, China’s GDP shrunk in Q1 2020, experiencing a 6.8% contraction.¹¹ A similar contraction was felt in the venture capital ecosystem. According to data sourced from Redpoint China Ventures, Chinese venture managers raised roughly 50% fewer funds in Q1 2020 compared to the same period in 2019. U.S. dollar-denominated funds saw a disproportionate drop of 85% in Q1 2020 year-over-year, leaving a vacuum in the venture fundraising landscape. This vacuum, coupled with the fact that many venture-backed companies will, for the first time in their short lives, need to conserve cash and focus on more immediate profitability, bodes well for a healthy venture ecosystem going forward.

Despite the overall negative impact to the economy, some verticals experienced rapid growth during the pandemic, especially those related to new technologies. Ecommerce, one of China’s most watched industries, saw explosive growth following the emergence of the COVID pandemic as the country’s citizens entered a period of social isolation. PinDuoDuo (NYSE:PDD), a fledgling e-commerce star in China, saw its stock price soar by over 170% since the outbreak began in late November 2019. Further, tech penetration has only accelerated in smaller, more distant cities, bringing additional consumers online and broadening the opportunity set for new and emerging start-ups. While COVID-19 is among the most devastating public health crises in history, initial observations lead us to believe that technology will be at the forefront of societal adaptation.

Boots on the Ground

As a firm founded with a global orientation, we have been an active investor in China (and Asia more broadly) since 2005, deploying over $500 million across primary and secondary investments in China-based funds and companies. While we feel fortunate to have built deep relationships with members of the venture and entrepreneurial community in the region over the last 15 years, we feel strongly that in any international market, especially one where cultural differences and physical distance are pronounced, trusted on-the-ground resources can be a strategic advantage to achieving success. As such, we recently opened a Beijing office, hired a longstanding advisor and native of Shanghai, Roger Li, and formed a consulting relationship with one of China’s leading venture capital platforms, Pantheon Asset (known as Pan Sheng in Mandarin) to deepen our investment practice in the region.

We have known and worked closely with Roger since 2002, having been an investor in his firm, InfoTech Pacific Ventures, since 2006. Roger has also served on our Industry Advisory Board, where his guidance was instrumental in helping us formulate an effective strategy in Asia. Further, Roger is a 20-year veteran venture investor with a vast network. Due to this long partnership with the firm, Roger is intimately familiar with our culture, values and playbook, and we are honored to have him lead our China practice. 

Pantheon was founded in 2010 by a team formerly of China Renaissance and Macquarie Capital as the first non-government funded venture capital fund-of-funds in China. Today, the firm manages over $2.4 billion and has deployed more than $1.6 billion to primary, direct and secondary venture capital opportunities. Pantheon exclusively focuses on locally denominated, or RMB, investments: funds, companies and secondaries that are generally not accessible to non-Chinese investors. Our relationship with Pantheon spans approximately five years, and we view our two firms as highly complementary as partners in this new initiative. Pantheon will enhance our existing investment sourcing, diligence and monitoring strategy in China in a variety of ways.

Conclusion

Globalization in venture capital is upon us. Today, China represents the key growth economy in the venture capital ecosystem. Its mix of demographics, attractive exit environment and decisively pro-technology government policies position it as a key geography worthy of meaningful allocation from institutional investors.

[1] Thomson Reuters. Data as of 12/31/2018. Figures shown above include RMB denominated funds.

[2] Thomson Reuters. Data as of 12/31/2018. Figures shown above include RMB denominated funds.

[3] U.S. Census International data sets. Data as of March 2019

[4] McKinsey & Company. Data as of March 2019

[5] Lightspeed China data as of May 2018

[6] Thomson Reuters and Pitchbook. Data as of 12/31/2018.

[7] Thomson Reuters and Pitchbook. Data as of 12/31/2018.

[8] South China Morning Post, “At the Heart of China’s Techno-Nationalism is a Hit List of 200 Unicorns.” Data is sourced from the 2017 China Unicorn Enterprise Development Report.

[9] South China Morning Post, “At the Heart of China’s Techno-Nationalism is a Hit List of 200 Unicorns.” Data is sourced from the 2017 China Unicorn Enterprise Development Report.

[10] ABC News “Made in China 2025: Beijing's manufacturing blueprint and why the world is concerned”

[11] CNBC “China says its economy shrank by 6.8% in the first quarter as the country battled coronavirus”