China's Big Tech Crackdown: Venture Capital Exit Plans Derailed?

Chinese technology giants are facing an onslaught of regulatory pressure at home and abroad, stoking fears for the fate of exit opportunities in the country’s booming VC industry

China’s venture capital market has exemplified everything a start-up hub could ever hope for at the bleeding edge of digital innovation. Home to some of the world’s most valuable technology giants, the country has rapidly soaked up international funding earmarked for promising early-stage investment opportunities. 

As of December 2020, Greater China-based venture capital industry assets under management (AUM) hit a record $518mn – surging more than 8.5x in just five years (Fig. 1). However, such acceleration seldom comes without growing pains. China is ramping up the regulatory pressure on its high-flying 'big tech' sector, fueled by concerns over cybersecurity breaches. What could this mean for the wider venture capital industry?

What Is Happening?
Cybersecurity concerns are proving detrimental to market value. Last week, the Cyberspace Administration of China (CAC) and its Cyber Security Review Office – a joint task force of 12 government ministries set up last year, including the Ministry of Public Security and the Ministry of National Security – alleged that ride-sharing super app developer Didi Global posed a significant “national data security risk.” As part of the probe, authorities also had the company’s mobile application removed from app stores in the country just days after it contentiously raised a staggering $4.4bn in the second-largest US IPO for a Chinese firm. Following the news, Didi’s American depositary shares on the NYSE tumbled below its $14 IPO debut price and wiped out around $22bn in market value on 13 July during trading hours. 

To the disappointment of many market-watchers, the spillover into other publicly listed Chinese technology giants was swift and immediate. A combined $823bn evaporated across the group, which includes notable names like Tencent, Alibaba Group, JD.com, and Baidu. Further, as selling pressure mounted last week, international exchanges outside of North America offered little salvation for traders. By Thursday, the Han Seng Tech Index in Hong Kong sank to a nine-month low, with the 30-member gauge losing 33% from its peak on February 17th – a loss of around $616bn in market capitalization. 

The contagion effects across markets reflect wider concerns over a rapid escalation in oversight by China’s governmental agencies in monitoring data privacy, protection, and security in the last year. The most publicly prominent crackdown by regulators in recent memory involved Alibaba-affiliate, financial technology powerhouse Ant Group. This led to the collapse of its highly anticipated dual listing in Shanghai and Hong Kong in November 2020, which was, at the time, widely expected to be the world’s largest IPO ever. 

Many of these fears over growing regulatory risks in China are quickly proving legitimate. After the Didi security-based probe, government officials also moved against two other US-listed companies – online recruitment platform Kanzhun and on-demand truck hiring company Full Truck Alliance – setting off a series of investigations on behalf of investors into possible US federal securities law violations. 

These surprise moves sent shockwaves through the global tech industry. Chinese authorities have signaled a strong pivot from unfettered growth at all costs, toward rules and official guidance carrying more weight in the decision-making processes of technology founders, capital providers, and other stakeholders. It also highlights that agencies are confident in their belief that big tech is not, and should not, be too big to regulate – a feeling quietly shared with many counterparts around the world.   

Why Does it Matter for the Venture Capital Industry?
For providers of early-stage financing, the big tech crackdown is adding to a long list of hoops to jump through to successfully exit portfolio companies. Venture capital fund managers active in China have already had to contend with rising policy uncertainties on both sides of the Pacific in recent years. Indeed, the tit-for-tat bickering that has defined US-China trade relations since 2018 has cooked up a ‘spaghetti bowl’ of overlapping restrictions, covering everything from soybeans to sweeping moves by the Trump administration to strengthen federal powers and delist Chinese firms tapping into US capital markets. Put simply, the venture capital market appears much less inviting for industry practitioners.

That said, existing headwinds have done little to dissuade deal-makers from deploying capital. Nor has it quelled enthusiasm for soaring blockbuster IPOs on foreign stock exchanges. Aggregate deal value across Greater China has been on a tear, reaching a quarterly peak of almost $37bn in Q1 2021, led primarily by consumer technology-oriented companies (Fig. 2). More impressive, perhaps, is that despite a slight slump in the second quarter of this year, H1 2021 total deal value stands at more than $67bn – the highest-level seen in recent years. 

On the exit front, a very healthy $65bn was raised via IPO by venture capital-backed companies in Greater China for 2020, more than the two years prior combined (Fig. 3). Exit traction this year remains robust thus far, with close to $50bn already raised in public equity markets as of June 2021.

That being said, while the impact of the latest regulatory changes will take time to manifest in private market transaction data, it seems things are getting a bit darker before the dawn. In the latest blow to the big tech sector, the CAC has announced proposed rules this past Saturday that would require all companies holding data on more than one million users seeking to list in foreign countries to undergo a cybersecurity review – a low threshold for a country with one billion internet users. The cybersecurity review will also investigate potential national security risks from overseas IPOs.

The move shines a spotlight on the longstanding, albeit contentious, use of Variable Interest Entities (VIEs). This is a common corporate structure used to circumvent restrictive overseas listing rules enforced by the China Securities Regulatory Commission – made up of Chinese companies like Tencent, Baidu, and Didi Global to tap Western capital markets. Regulators are also considering requiring VIEs such as Alibaba that have already gone public to seek approval for additional share offerings in an offshore market.

Revised listing rules will be top of mind for venture capital fund managers planning exit strategies in the near term. Indeed, foreign listings of Chinese companies are a significant funding option for mature portfolio assets and US exchanges have drawn a large share of these opportunities. Over the past decade, Chinese firms have raised a whopping $76bn through first-time share sales in the US public equity market. For Wall Street, this has meant big business that is currently at risk of slowing as companies take a pause on American listing plans. Indeed, major US banks have soaked up $6.4bn in underwriting fees from offshore IPOs in the US since 2014. For Beijing, these capital flows are likely increasingly troublesome for a country that wants to encourage domestic capital reliance and self-sufficiency for growth at home. 

A Hong Kong-based lawyer advising Chinese technology companies and venture capital firms, who asked to remain anonymous given the sensitivity of ongoing regulatory discussions, told us there has been an increase in the number of clients revaluating their US-listing plans in light of recent developments. However, the legal advisor also explained that this is “obviously not the only route to public markets for quality companies looking to tap into public financing,” and could bode well for other popular listing destinations like Hong Kong and Shanghai. 

While it is true that reforming national data security rules and listing practices have acquired a strong sense of urgency in China, these moves are not entirely new and have been on the government agenda for years. Fund managers have had to navigate uncertain regulatory waters before – adapting will likely just take some time.

The Global Future of ‘Big Tech’ is Bigger Regulation
One thing is certain, however, increasing regulation of big tech in China should not be a surprise for private capital players and, in many ways, is somewhat overdue. The ubiquity and pervasiveness of global technology platforms have sparked an outpouring of concern over data privacy and security from governments, companies, and consumers around the world in recent years. 

For example, the EU introduced the General Data Protection Regulation (GDPR) in 2018 – to significant fanfare for its added operational complexity for firms that needed to comply. And in the US, lawmakers are currently debating a significant overhaul of antitrust legislation aimed at curbing the far-reaching powers of big tech firms – much to the ire of technology giants and investors.

In this digital age venture capital players should expect more regulation rather than less. Moreover, investment due diligence will increasingly need to weigh the potential societal impact of platform services built on the collection, use, and distribution of personal data to be sustainable no matter where business activities take place. Adapting to and compliance with the dynamic global regulatory landscape offers opportunities for fund managers and their portfolio companies to develop a persistent competitive advantage over those that cut corners for growth.

In the short term, it is important to remember that proactive government involvement in digital innovation across China is what facilitated an unprecedented gold rush for the venture capital industry in the first place. This will remain the case, as the race for global technology dominance puts upward pressure on demand for resources and the need for consumer protection. That said, ensuring the benefits of rapid innovation and growth accrue to benefit the many and not the few is a constant balancing act for policymakers – a struggle they are still trying to figure out.