VC activities in China have already been eyeball-grabbing: US$100m seed round for a startup, Series A to C within six months, etc.
However, the mood seems to have turned sombre recently. Anyone who is in the circle keeps hearing the rumour: the tap is becoming dry. Both VCs and PEs find it hard to raise money since beginning of the year. And of course, this in turn makes them more cautious when investing into companies.
A common advice you would hear in the chatter in Shanghai or Beijing (or on the high speed rail between the two cities) – get your funding fast, stock up for winter.
Effects of de-leveraging
A main culprit, according to many, is the government’s attempt to reduce the excess leverage in the financial system.
To understand how this came about, we have to go back to history.
In 2008, in response to the international financial crisis and weak internal demand, China launched credit expansion and added leverage to stimulate the economy. However, the rapid growth of overall credit and the exploding credit of shadow banks raised concerns about China’s debt problem.
Leverage, in layman’s terms, is: You have $300,000, plan to buy house worth one million dollars, and then you borrow $700,000 from the bank. In finance, the 700,000-dollar loan is leverage. The process of borrowing money in debt is a process of adding leverage. And the process of repaying loan is the process of deleveraging.
Simply put, leverage is high investment, high borrowing/debt, high risk, and high returns. On the contrary, deleveraging is a way to reduce investment with high risks (while also reducing the returns on equity), and to reduce existing liabilities.
For enterprises, de-leveraging and reducing loans will shrink production scale, and strengthen the management of debt in upstream and downstream.
As a result, capital costs will increase in the whole market rise, and the funds will be further tightened. For investors, the investment environment may worsen due to government regulation and tightening capital pools.
Translate that into VC & PE industry – for many years since 2008, it was so easy to raise money as the LPs were taking lots of leverage themselves, and much of the capital raised eventually came from banks, many of whom state-owned.
While there are not that many sound investment opportunities in China – debt market is a mess, and try asking a Chinese fund manager what an ETF is – many of the excess liquidity went into the property market.
The regulators have been really trying their best to avoid systemic risk – and de-leveraging seems to be the only way. This will be painful for some parts of the economy.
Hence many LPs are running out of excessive liquidity, and funds find it hard to raise additional capital.
High valuations & poor returns
Of course, this is not the only reason why many PE/VC funds are having difficulties raising money. The explosion of VC activities in 2013-2014 led to many amateur GPs making unwise decisions – and money lost at a grand scale.
So without exits, it is quite hard to convince people to give you more money to invest in.
Investors of businesses that managed to survive and thrive find it hard to exit through IPOs in China – the approval process has become long, and success rate low. The regulators are keen to avoid too much risk in the domestic equity market.
Another problem of excess VC activities back then drove valuation sky high – many of the unicorns are, frankly, very expensive. Getting them listed through IPO might result in a sharp (downward) adjustment in valuation – another phenomenon that Chinese regulators do not like.
What might happen is that…
For one thing
For some entrepreneurs and startups, it’s really hard to find the qualified investors and the exact amount of funds in current market.
The start-up investment industry is featured with high risk and high returns. If investors are unwilling to take risks out of objective reasons, it means they will not make big investments.
But from another point of view, this can also be seen as a natural evolution of the venture industry by market.
The reduced capital pool makes VCs more cautious, and kicks out poorly-performing VCs. And only the truly brilliant, reliable and promising projects will get their favor. Such projects will also worry less about inherently-weak, but capital fuelled competitors.
In the long term, the change is not all bad. It happens endlessly that the market and stock market make quick money. And increasing startups established one or two years ago queued for IPO. Impetuous society drives people to profit in business opportunity, while the real down-to-earth companies may attract less attention, and some really meaningful projects may thus develop slowly.
That said, it is not impossible that the government will relax the rules of de-leverage to avoid stagflation. Even if they do not, by the natural economic cycle, the market will warm up again, sooner or later.
So indeed, having stock of hay is good for GPs, startups and unicorns.
How about the current unicorns?
For highly-valued current unicorns, IPO in Hong Kong seems to be the way to escape this difficulty. Following Xiaomi’s lead, a number of ecommerce, fintech and other internet unicorns are queuing to get listed in Hong Kong. Rumours are saying that Didi and Meituan are also on that route.
The public market, however brutal, would at least keep them afloat.
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