The U.S.–China Investment War
Through the lens of a venture investor
Many global investors, including myself, are waiting for clarification on an executive order that Biden is reportedly close to signing that would limit outbound U.S. investments into China—specifically in technologies such as semiconductors, AI, and quantum computing. While the extent of the restrictions remains unclear, it is just another signal that the U.S.-China investment war is intensifying. In this piece, I will recap the U.S.-China investment war, discuss where I see it going, and outline its implications for entrepreneurs and venture investors.
How we got here
With the help of New Bing and ChatGPT, I summarized below key events that define and intensify the U.S. and China investment war.
The U.S.-China investment war intensified around 2017 when the U.S. government began blocking and intervening in Chinese investments and acquisitions of U.S. companies. Notable deals that were blocked include Ant Financial Group’s $1.2 billion acquisition of MoneyGram and Canyon Bridge’s $1.3 billion acquisition of Lattice Semiconductors. In August 2018, Trump enacted the Foreign Investment Risk Review Modernization Act (FIRRMA), which requires any foreign investment in U.S. companies involving critical technologies or personal data be reviewed by the Committee on Foreign Investment in the United States (CFIUS). He further pressured certain federal pension funds to halt investments in China stocks and prohibited U.S. investments in companies identified as "Communist Chinese Military Companies.”
As a result, Chinese VC investment in U.S. startups was cut half to $2.3 billion in 2019 after the enactment of FIRRMA. Invested value grew again in 2020 because of a few large transactions in healthcare, pharmaceuticals, and biotechnology, but the transaction count continued to decline at a fast rate.
Biden’s proposed executive order—which observers are calling a “reverse CFIUS”—would compound the restrictions imposed by Trump and might cause a similar level of U.S investors departing from China as CFIUS did to China investors.
Interestingly, as much as China and the U.S. disagree on many fronts, it seems that they want the same result from the investment war. In China, many private and public companies in high-tech sectors are already structured as onshore companies (meaning, U.S. investors can’t invest in them any way regardless of any restrictions imposed by Washington), in order to take advantage of China’s self-reliance policy tailwinds, which open the door to listings on the Shanghai and Shenzhen exchanges, and contracts with State-Owned Enterprises (SOEs) and other government entities, which normally only work with companies fully owned by domestic shareholders. China has also created additional hurdles this year by requiring Chinese companies seeking overseas listings to complete a review process with the China Securities Regulatory Commission first, which has the power to reject the filings of any overseas offering and listing application.
Where is this going?
Unfortunately, I think that the divergence of the two countries’ venture capital markets will only get worse over time and here’s why:
Weaponization of venture capital
Venture capital was not an institutionalized asset class during the Cold War and was an overlooked aspect of geopolitical tension until recent years, as it has become an important vehicle for accessing innovation and impact, and thus interacted with Washington and Beijing to a greater degree. The recent development of AI and the importance of the already-sensitive semiconductor to AI development have put venture capital at further risk of being weaponized.
Legislation like CFIUS is intentionally vague. This essentially gives regulators free rein to weaponize transactions and decide on investments case by case, without establishing standards by which VCs can approach their intended investments. As a result, companies and investors ultimately choose the most conservative option: to not invest or take their money elsewhere, especially when they are not lack of domestic options. I expect Biden’s reverse CFIUS order to be similarly vague, and intentionally so. For example, AI is rumored to be included in Biden’s executive order. If the order does not clearly define the industries to be covered, the scope of the order is virtually without limit given the widespread use of AI at tech companies across the board.
Another example is that more and more entrepreneurs in both the U.S. and China are establishing their headquarters in places such as Singapore and Ireland as a way to neutralize the company’s nationality and sidestep the geopolitical tensions that can scare away global investors. However, this doesn’t solve the problem, not when the two governments determine the scope of the businesses to be regulated. Just look at Tiktok. In its attempts to restrict investments in China, the U.S. could easily say that a “Chinese business” includes one that derives most of its revenue from, has a majority of its team in, or has some “special” ties to China, regardless of where its headquarters is. As much as a company may look global on the surface, geopolitical tensions can change that for the purposes of competition and regulation.
High growth sectors in China today are atypical venture investments for U.S investors while more and more want RMB than U.S. dollar.
In 2004, Silicon Valley Bank organized a team of well-known U.S. venture capitals, including Sequoia, KKR, Redpoint, NEA, and others to visit China. Enthusiasm for China ignited, and many of them established China practice afterwards. This marked the beginning of a golden era for U.S. dollar funds, and many of these funds 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. The openness of China just after it joined the World Trade Organization, the immaturity of the domestic capital markets, and the match between the Internet business model and risk appetite of U.S. venture capitalists made it the perfect time for U.S. funds to enter China.
However, the China growth story began to change in the mid 2010s, along with the capital markets landscape in China. Outlined in the CCP's 14th Five Year Plan, China made the development of critical technologies in fields such as AI, semiconductor, clean energy, and manufacturing its key priority. Most of these priorities involve advanced technology development with long R&D cycles, hardware, traditional industries, heavy services, and low gross margins, which are atypical investments for U.S. venture funds. Investors in these sectors require a totally different skill set to evaluate startups, as well as a different risk and return profile typically offered by Silicon Valley-type startups. Add to this the increasing tendency for Chinese companies to be formed onshore, cutting Western investors out of the game, and domestic RMB funds begin to play a critical role in supporting Chinese startups and they’re gradually replacing U.S. dollar funds across sectors and being rewarded for knowing the China playbook.
In response, it’s worth noting, a number of U.S. venture capital funds such as Sequoia and LightSpeed, which have a long history of investing in China, have already raised RMB funds alongside their U.S. dollar funds to tap into this market and RMB funders in local government, SOEs and other domestic investment sources. Qiming Ventures, which started out as a U.S. dollar fund, just closed its RMB Fund VII of RMB 6.5 billion (equivalent to $940m), making it the largest RMB fundraising in China’s venture capital market so far in 2023.
‘China discount’ prevails, making U.S. investors less attractive to Chinese companies while China incentivizes companies to raise and list domestically.
There are multiple factors contributing to the valuation discount that Western investors put on Chinese companies today. First, in addition to U.S.–China geopolitical tensions (Taiwan included), the absence of predictable and transparent policies from China is scaring away foreign investors. In July 2021, the Chinese government wiped out $100bn+ private tutoring sector overnight where many notable western investors invested billions of dollars into. In the same month, China unexpectedly announced security investigations into three newly listed Chinese companies on U.S. exchanges, including the ride-hailing giant DiDi. This month, China began a targeted investigation into foreign consulting firms operating in China 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 $20bn profit in 2022 but is trading at single-digit profit multiples for its secondary shares today. KWEB, a China Internet ETF with free floats outside China, dropped 74% since its peak in February 2021, compared to S&P 500’s 6% gain during the same period.
On the other hand, China domestic exchanges embrace and offer premiums to companies following the China strategy. China has also been rolling out initiatives to attract innovative companies to list domestically, including the expansion of the registration-based IPO system across domestic boards to shift away from the approval-based IPO regime this year, and the launch of the Shanghai Stock Exchange Science and Technology Innovation Board (the STAR Board) in 2019.
Suggestions for entrepreneurs and venture investors
Both U.S. and China are making it hard to invest in either country. The abundant domestic options will also make venture investors and entrepreneurs less dependent on each other over time, compared to other harder-to-replace global flows such as goods and services, etc. It is important for entrepreneurs and investors to:
Let go of your wishful thinking that things will go back to the way they were—they won't.
Be prepared to choose one side, rather than attempting to triangulate a way to balance both.
Acknowledge that national interest will take precedence over economic interest when geopolitical tensions intensify. Do not attempt 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 LPs. 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 nor free. The process can be made easier if you receive organic inbound interests from overseas customers before building out a full time overseas team, or if your business is inherently cross-border in nature (i.e cross-border e-commerce, payments).
Bear with me if I sound pessimistic, but I want to stay honest with my views. With that said, in my next piece, I will address the U.S. and China Trade War and the new opportunities that I see it creating for entrepreneurs and venture investors, which I am truly excited about. Subscribe here for my next piece (and more optimism!).
Excellent piece!