Adapting to the New Environment: A Sea Change in China’s Venture Capital Landscape

The Chinese venture capital landscape that once thrived on giant U.S. IPOs of consumer companies is undergoing a significant transformation. The urgency to adapt to this new environment has intensified in recent years due to stricter regulations in China and the U.S., geopolitical tensions, and a slowdown in the world’s second-largest economy. Here are the three major shifts taking place in this evolving market:

1. From U.S. dollars to Chinese yuan
The traditional business model for well-known venture capital funds in China, such as Sequoia and Hillhouse, involved raising dollars from limited partners in the U.S. These funds were then invested in startups in China, which eventually sought initial public offerings in the U.S., generating returns for investors. However, with Washington increasing its scrutiny of U.S. money backing advanced Chinese tech and the difficulty for Chinese companies to list in the U.S., venture capitalists in China are turning to alternative sources. These sources include the Middle East and, increasingly, funds tied to local government coffers. The shift towards domestic channels also means a change in currency.

In 2023, the total venture capital funds raised in China dropped to their lowest since 2015, with the share of U.S. dollars falling to 5.3% from 8.4% in the previous year. This is a significant decrease from the previous years, where the share of U.S. dollars in total VC funds raised was around 15%. The remaining share was in Chinese yuan. Currently, many USD funds are focusing on government-backed hard tech companies, which typically aim for A share exits rather than U.S. listings.

For foreign investors, high U.S. interest rates and the relative attractiveness of markets such as India and Japan also factor into decisions around investing in China. “VCs have definitely changed their view on Greater China from a couple years ago,” said Kyle Stanford, lead VC analyst at Pitchbook. “Greater China private markets still have a lot of capital available, whether it be from local funds, or from areas such as the Middle East, but in general the view on China growth and VC returns has changed.”

2. China investments, China exits
The resolution of the long-standing audit dispute between the U.S. and China in 2022 reduced the risk of Chinese companies having to delist from U.S. stock exchanges. However, following the fallout over Chinese ride-hailing giant Didi’s U.S. listing in the summer of 2021, the two countries have increased scrutiny of China-based companies wanting to go public in New York. Beijing now requires companies with large amounts of user data to receive approval from the cybersecurity regulator before they can list in Hong Kong or the U.S. Washington has also tightened restrictions on American money going into high-tech Chinese companies. A few large VCs have separated their China operations from those in the U.S. under new names.

“USD funds in China can still invest in non-sensitive sectors for A share IPOs, but have the challenge of local enterprise preferring capital from RMB [Chinese yuan] funds,” said Liao Ming, founding partner of Beijing-based Prospect Avenue Capital, which has focused on U.S. dollar funds. “The trend is shifting towards investing in parallel entity overseas assets, marking a strategic move ‘from long China to long Chinese.'”

“With U.S. IPOs no longer being a viable exit strategy for China assets, investors should target local exits in their respective capital markets—in other words, China exits for China assets, and U.S. exits for overseas assets,” Liao added.

Only a handful of China-based companies – and barely any large ones – have listed in the U.S. since Didi’s IPO. The company went public on the New York Stock Exchange in the summer of 2021, despite reported regulatory concerns. Beijing promptly ordered an investigation that forced Didi to temporarily suspend new user registrations and app downloads. The company delisted later that year.

The probe, which has since ended, came alongside Beijing’s crackdown on alleged monopolistic practices by internet tech companies such as Alibaba. The clampdown also covered after-school tutoring, minors’ access to video games, and real estate developers’ high reliance on debt for growth.

3. VC-government alignment, larger deals
Instead of consumer-facing sectors, Chinese authorities have emphasized support for industrial development, such as high-end manufacturing and renewable energy. “Currently, many USD funds are shifting their focus to government-backed hard tech companies, which typically aim for A share exits rather than U.S. listings,” Liao noted. These companies include developers of new materials for renewable energy and factory automation components.

In 2023, the 20 largest VC deals for China-headquartered companies were mostly in manufacturing and included no e-commerce business. In pre-pandemic 2019, the top deals included a few online shopping or internet-based consumer product companies and some electric car start-ups. The change is even more stark when compared with the boom around the time online shopping giant Alibaba went public in 2014. The 20 largest VC transactions for China-headquartered companies in 2013 were predominantly in e-commerce and software services, according to PitchBook data.

The shift away from internet apps towards hard tech requires more capital. The median deal size in 2013 among those 20 largest China VC transactions was $80 million. That’s far smaller than the median deal size of $280 million in 2019 and a fraction of the median of $804 million per transaction in 2023 for the same category of investments. Many of those deals were led by local government-backed funds or state-owned companies, in contrast to a decade earlier when VC names such as GGV Capital and internet tech companies were more prominent investors.

“In the past 20 years, China and finance developed very quickly, and in the past ten years private [capital] funds grew very quickly, meaning just investing in any industry would [generate] returns,” said Yang Luxia, partner and general manager at Heying Capital, who has been focused on yuan funds while looking to raise capital from overseas. “I don’t expect the same pace of growth going forward, and I’m even taking a ‘conservative’ approach to new energy. The technology changes quickly, making it hard to select winners, while companies now need to consider buyouts and other alternatives to IPOs.”

Then there’s the question of China’s growth itself, especially as state-linked funds and policies play a larger role in tech investment. “In 2022, [private equity and venture capital] investment in China was cut in half, and it fell again in 2023. Private and foreign actors were the first to withdraw, so the venture capital scene has become even more state-concentrated and focused on government priorities,” said Camille Boullenois, associate director, Rhodium Group. “The risk is that science and technology becomes ‘more state-directed and aligned with government’s priorities.’ That could be effective in the short term, but is unlikely to encourage a thriving innovation environment in the long term.”