Beijing – Investors are pouring capital into China’s more mature, later-stage tech companies, polarising the tech scene into established “decacorns” – private companies with valuations of US$10 billion or more – versus capital-hungry, start-ups.

Unlisted technology giants are attracting bigger and bigger private fundraising rounds, leaving less on the table for start-ups who need to raise their first two critical rounds of financing to get off the ground and scale up.

A polarised market in which early-stage financing is sidelined could frustrate entrepreneurship and stifle innovation. After all, it is that kind of financing in recent decades that catapulted Baidu, Alibaba, Tencent and the like into global tech giants.

So it’s not an easy time to have big dreams if you are a unicorn – a tech start-up valued at US$1 billion or more – or a wannabe unicorn.

Last year, eight unlisted companies valued at US$10 billion or more got venture capital investment. In 2017, the number was just one, according to data from Preqin.

 “On both the capital-raising and investing sides, the Chinese market is getting more polarised. You see a lot of capital going into billion-dollar mega funds, leaving behind a lot of smaller funds that could not raise sizeable US dollar funds,” said Cheng Yu, a partner at early-stage Morningside Venture Capital, who was speaking at a panel of the Hong Kong Venture Capital and Private Equity Association conference in January.

The tilt toward decacorns comes as China last year surpassed the US as the home of the world’s top venture capital deals, with seven of the top 10 deals going to Chinese private tech companies. The moment was so breathtaking that some market observers have taken to calling 2018 the “Year of the Red Unicorn.”

Chinese decacorns include Ant Financial, an online payment and financial services platform operator, which last June raised US$14 billion of private funding, and Bitmain, a bitcoin mining integrated circuit chips designer that was seeking last August to raise up to US$18 billion via a stock market listing, but its success to list on the Hong Kong main board also remains in doubt . (Ant is an affiliate of Alibaba Group Holding, which owns the South China Morning Post.)

Another is Beijing Bytedance technology, the world’s most valuable start-up reportedly worth US$79 billion, ahead of US-based Uber Technologies.

‘Flight to quality’

But behind the eye-catching headlines, China’s venture capital market is showing signs of trouble in grooming unicorn heirs.

Part of the reason is less frothy valuations, and a fundraising “winter” in which newly raised China-bound venture capital investment funds have dropped by 13 per cent in 2018, to 302.5 billion yuan, according to data from research provider PE Daily.

Since last year, there have been fewer deals being done for early-stage start-ups. Deals are taking longer to close, and fund managers are facing mounting challenge to raise early-stage VC funds, according to various venture capital managers and tech start-ups.

Things weren’t help by China’s equity market – which ended last year as the world’s worst major market. Meanwhile, new regulations introduced in 2018 drastically reduced managers’ avenues to raise renminbi funds.

The result: China venture capital market sank into a self-feeding loop of bifurcation – with more capital going into growth, and later-stage tech companies, while early-stage start-ups starved for seed, or below series-B capital struggling to get investors’ attention.

A “flight to quality” investment trend amid the reduction of fresh venture funding meant private equities and venture capital funds are willing to accept lower exit returns by allocating more funds on less risky investees that are closer to initial public offerings (IPOs).

The valuations of a start-up varies hugely as it matures, as shown in the listing prospectus of Hua Medicine, a developer of diabetes drugs that went public in September in Hong Kong under revamped rules that allowed biotech companies without profit or even revenue to list.

Its IPO valuation is 19 per cent higher than its most recent Series E private shares sale; 42 per cent higher than the earlier Series D; 57 per cent higher than its Series C; 3.5 times higher than Series B and 18 times higher than the earliest Series A round.

In 2018, the number of China-focused early-stage funds raised totalled 111 funds, or RMB18.19 billion yuan (US$2.7 billion), down 24 per cent and 8.8 per cent respectively from a year ago, PE Daily data shows. Of these, the bulk of 103 were renminbi funds; with the rest being US dollar funds.

Overall, in terms of private equity investment strategies, up until November 2018 as much as 47 per cent of the investors’ money raised last year went to funds that focus on growth equity, or more mature companies typically with proven business models looking for growth capital, while 28 per cent went into venture capital funds, according to data from China Venture.

Cheng of Morningside Venture Capital said the state of China start-up scene in 2018 has languished from the heyday for start-up investing in 2014-15.

During those years, the number of start-ups flourished, and even those that were not top-tier players in the market did not have to worry about fundraising because of the ample pool of capital waiting to be deployed.

One beneficiary of the boom times was ZhongAn Online P&C Insurance. Backed by Ant Financial, Tencent Holding and Ping An Insurance, the online insurance start-up raised HK$11.5 billion (about US$1.5 billion) via its Hong Kong listing in September 2017, two years after receiving 5.78 billion yuan of pre-IPO investment.

Its stock has fallen 55 per cent since market debut as investors’ exuberance for tech stocks flattened.

After the third quarter of 2018, “the valuation correction that people have been talking about over the past three years is finally happening,” Cheng said. “Today if you are not the number one or two player in the market, it’s getting harder to get money.”

A fundraising ‘winter’

But companies that lead in their market segments and are backed by well-known investors are seeing none of that.

Ant Financial is one point in case. Its massive US$14 billion series-C round in June 2018 broke records as the biggest round raised by any unicorn. The capital provided by the line-up of leading institutional investors – with Temasek, Canadian Pension Fund Investment Board, Carlyle, Sequoia China, Warburg Pincus and Primavera Capital – has in turn propelled its valuation to US$150 billion.

The yuan VC market of 2018 has been quite bearish, and that valuations have also declined across the board, according to Nisa Leung, managing partner at Qiming Ventures Partners, which has backed more than 280 Chinese start-ups and currently has some US$4 billion under management in both US dollar and renminbi funds.

This makes VC partners that have already started due diligence on a prospective investee company think twice before committing further.

“Just over a year ago, VCs could easily close a deal within three months, and some would issue term sheets even before due diligence had been completed to increase their chances of winning a deal. Nowadays, diligence may take six to nine months,” she told the Post.

“Given the slump in the stock market, those that have signed term sheets and completed due diligence may decide not to sign the sales and purchase agreements,” Leung said.

The poor performance of China’s equity markets last year has meant that for those private equity and venture capital funds that choose to exit their investments through a public market listing, the valuations that their portfolio companies can get sold at from their initial public offering could be negatively impacted. The prices at which these investors could sell down their remaining shareholdings after the lock-up period expires might also get impacted by the overall downward market.

To be sure, “hot” deals do not lack willing suitors, but Leung said there are also deals that only get done after a discount of the selling price.

“Valuations have also declined. Even for ‘hot’ segments like artificial intelligence applications, their valuations have fallen by 20-30 per cent. For new drugs developers, some VCs have become more risk-adverse by sticking to companies closer to commercialising their products rather than earlier-stage, riskier start-ups,” Leung said.

The chairman of artificial intelligence solutions provider Shanghai Xiaoi Robot Technology echoed that view, adding that Chinese start-ups face tough scrutiny from prospective angel and venture investors, who tend to be more sceptical about Chinese innovations.

Max Yuan Hui said the biggest challenge facing China’s technology firms is a lack of real innovation in core technology. Angel and venture investors tend to question a Chinese start-up firm whether its technology already has a US-equivalent showing that the technology and business model works.

“This makes it extremely challenging for start-ups to get funding for commercialising really innovative ideas. If one does have a truly innovative technology and is willing to take a long-term perspective to develop and commercialise it, I would suggest you seek foreign investment capital rather than renminbi onshore funding,” Yuan said.

Set up in 2001, Shanghai Xiaoi Robot Tech pivoted to enterprise AI software solutions targeting the finance, telecom, legal and medical sectors, after trying and failing to commercialise smart robots almost a decade ago. Its investors include state-backed financial conglomerate Everbright Group and e-commerce giant Alibaba Group Holding.

The fundraising “winter” in China dates back to new rules released in April 2018 issued by multiple regulatory agencies, including the People’s Bank of China, China’s securities and insurance regulators and the State Administration of Foreign Exchange.

Until recently, banks in China had issued short-term wealth management products and used the proceeds to invest into private equity investments. These banks then repaid investors by issuing another batch of short-term investment products, effectively rolling over its liability. The new rules have disallowed such practises.

The guiding opinion has also imposed more stringent eligibility requirements on the “qualified investors” that can participate in private equity and venture capital, effectively reducing the number of limited partners in private equity and venture capital.

Heavier regulatory scrutiny aside, Cheng said another major reason that China’s early-stage venture investing has lost its previous fizz is that China is finding itself stuck between tech waves.

“We are in between two technology waves, whereby the past wave of mobile internet is fading away and that we are still at the early stage of the new wave of AI, whereby innovation is slow to come by in general,” Cheng said.

Indeed, the next batch of Chinese unicorns might increasingly be dominated by those that excel in AI.

China aims to be the world’s leading power in AI by 2030, with annual industry earnings of more than 1 trillion yuan. President Xi Jinping in October 2018 said China must control the use of artificial intelligence and called on party members of the National Congress to apply the technology to propel the country’s growth, as China and the United States are locked in a new arms race for dominance in AI. The role of venture capitalists in enhancing China’s AI ambition will become increasingly important.

Lee Kai-fu, a leading venture capitalist who co-founded Sinovation Ventures with about US$2 billion assets under management, wrote in his book AI Super-powers, China, Silicon Valley, and the New World Order that the AI revolution will take time. Ultimately, he argues, it will disrupt different sectors and weave into our daily waves in a series of four waves – Internet AI, business AI, perception AI and autonomous AI.

The first two waves of internet and business AI are already here, having reshaped our digital and financial worlds in ways exemplified by their applications in stock trading and disease diagnosis. Perception AI is now digitalising our physical world, learning to and recognize our faces, under our requests, and blur the lines between the digital and physical worlds.

Autonomous AI, which will come last, will have the deepest impact on our lives, Lee argues. Self-driving cars, autonomous drones and intelligent robots will transform many aspects of our lives, the former president of Google China argues.

For Morningside Venture Capital, Cheng said he believes that the biggest opportunities during the upcoming tech wave will be AI-enabled consumer applications.

“The biggest opportunity would emerge from companies that are coping with the shifting of the technology waves. We see AI as the biggest tech trend in China. The opportunities will come from companies that could leverage the technology to disrupt the whole industry, as opposed to just servicing as a technology provider,” he said.

China’s innovative start-ups need hard cash. Landing it isn’t likely to get easier anytime soon. (SCMP)