Venture capital

Nowhere to hide: Chinese startups struggle to attract both private & public investors

Following a year of mega IPO flops, Chinese VC investment plummeted in the second quarter as private investors baulked at spiralling valuations. Staying private for longer will no longer be so easy for entrepreneurs.

Unprofitable, fast-growing Chinese startups have, for the last five years, been able to tap private investors flush with cash, allowing them to put off filing for an initial public offering and the associated public scrutiny of their accounts: that will no longer be the easy option.

China’s fund-raising machine has nurtured a herd of Chinese unicorns, privately owned companies valued at over a billion dollars, like Alibaba’s unit Ant Financial, ride-hailing giant Didi and ByteDance, the parent of video sharing app TikTok.

It now appears to be grinding to a halt.

Greater Chinese private investments plunged 77% in the second quarter to $9.7 billion from a record high of $41.3 billion a year earlier. Just 684 venture capital deals were sealed between April and June, half of the 1,366 inked during the same period last year, according to private markets data provider Preqin.

The average value per deal also sank year-on-year in almost every stage of the capital raising process except for the very earliest rounds such as angel and Series A investments. 

Meanwhile, the number of US and European VC deals continued to climb. Prominent venture capitalists cited the US-China trade war, China’s slowing economy, and spiralling valuations as well a lack of startling innovations as reasons for slowing their deployment of capital in China.

It’s also true that venture capitalists focused on Chinese startups have less capital to deploy. Capital raised by renminbi-denominated funds shrank to $6 billion last year from $21 billion in 2017. Growth in US dollar-denominated China funds did not nearly make up for that shortfall.

Most graphically, the underwhelming stock market performance of some of China’s most innovative companies since last year has proved a reality check for over-exuberant early investors.

“There is a gap between what public investors are willing to pay and the last round of private investors,” said Nisa Leung, managing partner at Qiming Venture Partners. The venture capital firm has made a name for itself over the past five years by backing unicorns such as Beijing-based smartphone manufacturer Xioami and Meituan Dianping, an online food delivery-to-ticketing services platform.

Xiaomi raised $5.4 billion during its Hong Kong IPO in June 2018. But since then its share price has dropped below its listing price of HK$17 to HK$9.44 as of July 12. It's the same story for Meituan Dianping. It raised $4.2 billion in September last year at HK$69 per share, but by Friday they had flopped to HK$65 each.

Nio, China’s answer to Tesla, last traded at $3.42. That is nearly half of the $6.26 IPO price it struck in September, making it harder for electric vehicle manufacturers to follow in its tyre tracks, said one executive at a rival firm.

“People are coming back to reality and saying if we want to make money then we have to make sure the valuations are not too high,” said Qiming’s Leung, who was speaking at the RISE conference for startups in Hong Kong on July 9.

Loss-making Chinese movie ticketing app Maoyan Entertainment’s February IPO valued the company at $2.16 billion, less than the $3 billion during its 2017 funding round.

SHOW US THE MONEY
Traditionally, corporates have raised seed, angel, then capital for growth and expansion. They would then go public to raise further capital to fund their growth, provide liquidity to their early investors and raise their profile.

In recent years, new rounds of capital raising have been sandwiched in before an IPO which have been dubbed Series A through to series G. Didi is an outlier after completing 17 rounds of fundraising according to Crunchbase. A round in 2017 valued the company at $56 billion. 

Ant Financial was valued at a whopping $150 billion in its Series C round in June 2018, while ByteDance scored a mooted valuation of $75 billion in its pre-IPO round last October.

“Companies are staying private roughly two times longer than in past cycles and we have seen late-stage valuations increase materially,” said Chris Emanuel, co-head of the technology investment group at Singapore sovereign wealth fund GIC in May.

That was then.

The IPO of loss-making ride-hailing startup Uber Technologies on May 10, one of the largest in history at $8.1 billion, was a turning point. It is now trading at $44 a share after floating at $45, which was already the low end of its marketed range.

Public investors are clearly less tolerant of an unprofitable firm still burning through cash in an effort to scale up against stiff competition than the private investors in Uber’s late-stage fundraising rounds. Now private investors are also more critical of their erstwhile darlings such as Didi.

“The question is whether or not Didi can ever turn profitable?” said Qiming’s Leung.

This presents loss-making unicorns such as Didi with a quandary. They need huge dollops of capital to keep operating but the reputational damage of a fund-raising round revealing a sliding valuation – a so-called down round – can be catastrophic. 

Asked when Didi is likely to IPO and when it could break even, Didi’s chief security officer Zheng Bu said on Wednesday at RISE that “Didi never published a timeline for IPO” and in the meantime “we’ve been improving our operational efficiency”. 

SILVER LINING
A sharp rise in the valuations of very young companies over recent years has created this mismatch of opinion between private and public investors. It has a knock-on effect for latter fundraising rounds as companies always aspire to a rising valuation.

Yuan Liu, a managing director at ZhenFund, reckons that valuations “have drastically come up”. He estimates that they have doubled in the past two years and are up 30% from last year. Liu has a broad view of the market as he studies around 200,000 deals annually, mainly seed and angel rounds of capital raising.

There is a silver lining.

Harry Man, a partner at venture capital firm Matrix Partners, is looking forward to less competition for deals and the chance to take larger percentages of companies.

Man, who focuses on early-stage technology companies and looks at about 7,000 to 8,000 deals a year, said that 10 years ago he could easily get 20% of a company. “Currently when we first step into the company we can only get 10% or maybe max 12%, and oftentimes we have to split it with a co-investor,” said Man. “That actually hurts a lot more than how much more expensive these deals are getting,”

Others also see the rut in capital raising as an opportunity to access the “winners” among startups. Hans Tung, a managing parner at GGV Capital, has had more than his fair share of successes after backing 15 unicorns. He is sanguine about the downturn: “There will always be ebb and flow”.

What’s clear is that investors will become more discerning over which companies to back.

For startups looking to raise capital, there is no easy option. If they can’t get capital privately they will have to face their moment of truth in public markets. 

 

Additional reporting by Carol Huang and Joe Marsh 

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