- by Candice Lee
- 23 November , 2022
Investors across the globe are waiting for clarification on an executive order that President Joe Biden is reportedly close to signing that would limit outbound US investments into China. The order would regulate investments in the semiconductors, AI, and quantum computing sectors.
While the extent of the restrictions is unclear, the order is just another signal that the US-China investment war is intensifying. But what salvos have been fired so far, and how is the war going to affect founders and investors? Let’s dive in.How we got here
The investment war between the two countries intensified around 2017, when the US government started intervening in Chinese investments and acquisitions of US companies. Some of the notable deals that were blocked include Ant Financial Group’s US$1.2 billion acquisition of MoneyGram and Canyon Bridge’s US$1.3 billion acquisition of Lattice Semiconductors.
In August 2018, then US president, Donald Trump, enacted the Foreign Investment Risk Review Modernization Act (FIRRMA), which requires any foreign investment in US companies involving critical technologies or personal data to be reviewed by the Committee on Foreign Investment in the United States (CFIUS).
Trump then pressured certain federal pension funds to halt investments in China stocks and prohibited US investments in companies identified as “Communist Chinese Military Companies.”
As a result of the enactment of FIRRMA, Chinese VC investments in US startups were cut in half to US$2.3 billion in 2019. The figure increased in 2020 due to a few large transactions in healthcare, pharmaceuticals, and biotechnology, but the number of deals continued to decline quickly.
President Biden’s proposed executive order – which observers are calling a “reverse CFIUS” – would compound the restrictions imposed by Trump and could cause US investors to depart China, similar to what CFIUS did to Chinese investors.
Interestingly, as much as China and the US disagree on many fronts, it seems that they want the same result from the investment war.
In China, many private and public firms in high-tech sectors are structured as onshore companies, meaning US investors can’t invest in them regardless of the restrictions imposed by Washington. This is so the Chinese firms can take advantage of policies that are favorable to companies fully owned by domestic shareholders.
China has created additional hurdles this year by requiring Chinese firms that want to list overseas to complete a review process with the China Securities Regulatory Commission. This commission has the power to reject the filings of any overseas offering and listing application.Where is this going?
Unfortunately, I think the divergence of the two countries’ venture capital markets will only get worse over time. Here’s why:
Weaponization of venture capital
Venture capital was an overlooked aspect of geopolitical tensions until recent years. That has changed as the sector has become an important vehicle for accessing innovation.
The recent development of AI and the importance of the already-sensitive semiconductor industry to AI development have put venture capital at further risk of being weaponized.
Legislations like CFIUS are intentionally vague and allow regulators to weaponize transactions and decide on investments case by case, without establishing standards that VCs can use going forward. As a result, companies and investors ultimately choose the most conservative option: to not invest or take their money elsewhere, especially when they don’t lack domestic options.
I expect Biden’s reverse CFIUS order to be intentionally vague as well. For example, AI is rumored to be part of Biden’s executive order, and if the order does not clearly define the industries covered, its scope is virtually limitless given the widespread use of AI at tech companies.
Another example is that more and more entrepreneurs in both the US and China are establishing headquarters in places such as Singapore and Ireland to neutralize the company’s nationality and sidestep geopolitical tensions. However, this doesn’t solve the problem, not when the two governments involved in the war determine which businesses are regulated.
Just look at Tiktok.
The US could easily say that a “Chinese business” includes one that derives most of its revenue from, has most of its team in, or has some “special” ties to China, regardless of where its headquarters are.
Growing sectors in China are atypical investments for Americans
In 2004, Silicon Valley Bank brought some top US venture capital firms to visit China. The trip was a hit, and enthusiasm for Chinese investments ignited shortly afterward.
This marked the beginning of a golden era for US dollar funds in China, and many of them generated outsized returns from their bets on Chinese internet platforms. Notable examples include Naspers investing in Tencent, SoftBank investing in Alibaba, Sequoia investing in Meituan, and SIG investing in ByteDance.
China’s openness after it joined the World Trade Organization in 2001, the immaturity of domestic capital markets, and the match between the internet business model and the risk appetite of US venture capitalists made it the perfect time for US funds to enter China.
However, the country’s growth story started to change in the mid-2010s, along with the capital markets landscape in China. Outlined in the Chinese Communist Party’s 14th Five-Year Plan, the country made developing critical technologies in fields such as AI, semiconductors, clean energy, and manufacturing its key priority.
Most of these sectors involve advanced tech development with long R&D cycles, hardware, traditional industries, heavy services, and low gross margins, which are atypical investments for US venture funds. Investors in these sectors require a different skill set to evaluate startups, as well as a different risk and return profile typically offered by Silicon Valley-type firms.
The increasing tendency for Chinese companies to be formed onshore and cut out Western investors also hurt US dollar funds.
In response, a number of US venture capital funds such as Sequoia and LightSpeed, which have a long history of investing in China, raised yuan funds alongside their dollar funds to tap into the Chinese market.
“China discount” prevails
There are multiple factors contributing to the valuation discount that Western investors put on Chinese companies today. First, in addition to US-China geopolitical tensions, the absence of predictable and transparent policies from China is scaring away foreign investors.
In July 2021, the Chinese government wiped out more than US$100 billion of the private tutoring sector overnight, hitting billions of dollars in Western investment. The same month, the government announced security investigations into three newly listed Chinese companies on US exchanges, including the ride-hailing giant Didi.
In May this year, China launched a targeted investigation into foreign consulting firms operating in the country due to concerns over leaks of national security information.
Second, it has also become difficult to bet on the global expansion of Chinese companies given the geopolitical friction. All these factors translate into valuation discounts: Bytedance generated close to a US$20 billion profit in 2022 but is trading at single-digit profit multiples for its secondary shares.
On the other hand, China’s domestic exchanges embrace and offer premiums to companies toeing the party line. China has also been rolling out initiatives to attract innovative companies to list domestically, including the expansion of the registration-based IPO system to shift away from the approval-based IPO regime this year.What should entrepreneurs and investors do?
Both the US and China are making it hard to invest in either country. Abundant domestic options will also make venture investors and entrepreneurs less dependent on each other over time. This means it’s important for entrepreneurs and investors to:Let go of the wishful thinking that things will go back to the way they were—they won’t. Be prepared to choose a side, rather than trying to balance both. Acknowledge that national interest will take precedence over economic interest when geopolitical tensions intensify. Do not try to use your commercial sense to anticipate government regulations. For VCs investing in geopolitically sensitive regions, think through your exit path and how to eventually get money back to limited partners. Add “wipe-out due to geopolitical tensions” to your outcome table and check if the weighted returns still justify the risk. For entrepreneurs expanding into geopolitically sensitive regions, acknowledge that global expansion is no longer easy or free. The process can be easier if you receive organic inbound interest from overseas customers before building out a full-time overseas team or if your business is inherently cross-border in nature.
Forgive me if I sound pessimistic, but I want to stay honest. That said, I do see some opportunities for investors, which I will outline in an upcoming piece.
This article originally appeared on Sisi Song’s Substack. It has been edited for clarity.