There may be plenty of venture cash floating around China, but returns remain scarce.
By Ming Liao
Liao is the founding partner of Prospect Avenue Capital, a China tech-focused growth fund.
China’s tech startups have received billions in private financing over the past two decades, with some of those companies going on to make warmly received public market debuts. In 2014, Alibaba had the largest initial public offering in history, raising $25 billion on the New York Stock Exchange. Bilibili, a youth-driven streaming giant, saw its price soar tenfold within three years of its March 2018 listing on the Nasdaq.
However, the glitz of China’s tech listings in the U.S. did little to address the long-standing concerns limited partners had about their returns. In 2019, as Preqin prepared its inaugural report on China’s private equity and venture capital markets, LPs were expressing particular concern about how much cash they were getting back relative to the capital raised. In finance circles, this is known as the distribution to paid-in ratio, or DPI.
Surely China’s U.S. dollar-denominated fund managers would have no issues realizing cash returns. Don’t China’s tech investors make a killing from IPOs?
On the contrary, cash returns are the problem.
Everything from strict regulations to low deal volume is blocking the exits for China’s investors, at least domestically. Without a route to U.S. markets, they’re basically stuck.
DPI reflects the cash produced from both public and private market exits. When no exits are realized, DPI is zero. Though China’s private markets are flush with venture cash, they have historically been unable to provide consistent exits to investors, meaning that almost all of China’s largest tech companies have gone public in the U.S. That’s become a problem the past two years, when the U.S. market has been essentially closed to Chinese companies-and no U.S. IPO means no investor returns.
Few private transactions succeed in China. Buyouts may be viable, but only for businesses in traditional industries with cash flow robust enough to offset any debt used to finance a deal, and only if they can withstand heavy anti-monopoly scrutiny from regulators. The same goes for mergers of tech peers-in July 2021, China’s regulators terminated the proposed merger of U.S.-listed Huya and Douyu, the country’s top two e-sports and videogame livestreaming platforms. Secondary funds, which purchase existing equity commitments from LPs before they are liquidated, are still in their infancy in China and thus cannot yet serve as a reliable exit option.
What of the public markets?
China’s domestic stock market indeed offers attractive valuations and stable liquidity. However, the China Securities Regulatory Commission screens potential listings for sustainable profitability and largely dismisses unprofitable, cash-burning tech startups. The Shanghai Stock Exchange Science and Technology Innovation Board, also known as the Star Market, launched in June 2019 against the backdrop of China’s push toward technological self-sufficiency, but has established a clear preference for hard tech companies over social platforms, e-commerce and other more commercial software businesses.
Even if a venture were to list successfully, general partners of dollar-denominated funds would have to wait patiently for additional approvals from the State Administration of Foreign Reserve to transfer post-exit gains to overseas accounts-after paying a 10% tax.
As for the Hong Kong stock exchange, its investors tend to favor profitable companies with stable dividend yields, such as those in real estate, finance and retail. HKEX requires money-losing startups to articulate a profitability plan in their prospectus and provide a meticulous forecast in their IPO application materials. Hong Kong’s Securities and Futures Commission has also long denied dual-class shares arrangements like weighted voting rights, which give owners disproportionate control over their companies-a key reason why HKEX lost Alibaba’s 2014 IPO to NYSE. Hong Kong’s securities regulator eventually yielded and began allowing weighted voting rights in 2019, albeit only for big-ticket IPOs that clear high market-cap hurdles.
Then there’s the liquidity issue. In 2021, HKEX’s daily turnover was $21.3 billion; in contrast, NYSE and the Nasdaq Stock Market clear anywhere from $400 billion to $500 billion each day. For those China tech stocks listed in both Hong Kong and the U.S., Hong Kong can provide only a small portion of their liquidity, making it tricky for investors to sell their shares. Unsurprisingly, HKEX has had fewer than 10 China tech listings in both 2020 and 2021.
That leaves a U.S. IPO as the best option for maximizing DPI—but there again, only if the company is big enough. The eight major IPO-underwriting banks-Goldman Sachs, Morgan Stanley, Citibank, JPMorgan Chase, Bank of America, Merrill Lynch, Credit Suisse, UBS and Deutsche Bank-brought a total of 119 Chinese companies public in the U.S. from 2011 to 2021, according to Dealogic, averaging just shy of 11 IPOs per year. That’s a drop in the bucket compared to the number of companies that raised money in China’s private market. According to startup database Cyzone.cn, from 2015 to 2021 between 2,500 and 2,800 Chinese startups received Series B to IPO financing per year.
From this, we can extrapolate two actionable insights:
1. GPs of China’s dollar-denominated funds-especially those running growth funds, must invest in companies they believe have U.S. IPO prospects. Without U.S. IPOs, GPs won’t be able to deliver real returns to their investors.
2. Dollar funds whose investments are concentrated in a single industry or sector will have a harder time delivering returns and will be exposed to sudden market downturns and new targeted regulations. Sweeping new regulations aimed at curtailing the excesses of ed tech and fintech companies, for instance, have cost specialized funds dearly.
All of this leaves GPs vulnerable to U.S. legislation as well. Chinese companies have faced delisting in the U.S. since the Holding Foreign Companies Accountable Act went into effect in December 2020. After years of negotiation, regulators reached an agreement to allow U.S. auditors access to China’s listed companies only in the past month, removing a key blockage in the China-to-U.S. IPO pipeline. The unprecedented international coverage of this turbulent negotiation further indicates that China’s private market tech investments are unquestionably an IPO-driven business.
Smart GPs-especially the ones running growth funds-are the ones asking themselves before ever picking up a checkbook:
1. Is this company among the potential 11 U.S. market debuts from China, or another one of the 2,500 privately backed companies?
2. If it can be successfully listed in the future, what is its exit timetable?
3. From the capital markets perspective, what is this company’s positioning? What is the most closely comparable public company and how is it valued?
Greater consistency and discipline mean more reliable returns for venture investors. As for what happens after those investors get their exit opportunities, there are no guarantees.
Ming Liao is the founding partner of Prospect Avenue Capital, a China tech-focused growth fund with $300 million under management. A Princeton-educated and Morgan Stanley-trained former investment banker, Liao has advised more than 1,000 institutional investors and is frequently cited for his views on China’s capital markets, regulation, and policymaking by global finance media. He can be reached at [email protected].