Demystifying the Investment Ecosystem in China

China is a highly active market with 3,683 early stage investments totaling $20.2 billion in 2016. It’s hard to believe that in just 13 years, China has transitioned from a country that established its first ever VC fund (IDG venture China) to the world’s second largest breeding ground of unicorns (39, just behind the US).

The country’s shining GDP numbers over the past two decades is no longer news. Now, the world is turning heads toward a new wave of successful companies: Chinese startups. This ranges from the well-known “giants” like Xiaomi (a consumer electronics company that was founded in 2010, became a unicorn in 2012, and hit a valuation of $45 billion in 2014) and Didi (a ride-sharing app that was founded in 2012, acquired Uber China in 2016, and now is valued at $34 billion), to up-and-coming “shakers” like Toutiao (an AI-powered news and information mobile app company that raised $1 billion in its last round of financing this April), and Mobike (China’s leading bike-sharing platform, which raised a $215 million Series D in early 2017).

China’s growing success and competitive edge can be attributed to two things: 1) key players that foster and grow the unique ecosystem, and 2) a changing landscape of new cities and industries. In this post, we explore China’s competitive edge and the startups that it’s enabling.

Key members in the ecosystem

Key members in the ecosystem are the Chinese government, local VCs, and startups and entrepreneurs.

The Chinese government

The Chinese government plays an unsurprisingly important role in the startup ecosystem by regulating, subsidizing, and funding the entire ecosystem.

Structurally influential. It might sound funny to have all the top investors like Bob Xu (Zhen Fund) and Neil Shen (Sequoia Capital) sit together in a classroom and take an exam, but it indeed happened last year. In China, all investment managers need to be licensed. This helps the government assess the investment capability of those fund managers because the government, as I discuss later in this post, is putting real money into those funds. It might seem a bit ludicrous to judge the fund and its partners by a ubiquitous exam, but some may argue that our love for examinations is almost a cultural heritage (for example, our impossible service examination system dates back to the Qing dynasty). Jokes aside, the exam does provide a quick screening mechanism for government officials who might take ages to understand what “IRR” even means.

And highly supportive. The government is also very strategic about shifting the labor-driven economy to a more productive technology-driven model. Up to 20% of China’s trillion RMB National Social Security Fund is allocated to VC/PE investment, and billions of RMB has been set aside in a Government Guiding Fund (GGF) to invest in strategic areas like Industry 4.0. For example, Prosperity Investments is one of the biggest GGFs, with $10 billion AUM. Over 900 GGFs have been set up to facilitate the country’s economic restructuring.

Yet still predominantly relies on the private market mechanism. Despite the outpouring of government money, the Chinese government chooses to leverage or rely on the knowledge and expertise of proven professional investors. GGFs have primarily adopted the format of fund-of-funds, letting those professional investors make decisions. Top VCs like IDG, Sequoia, and Shenzhen Capital have all raised new funds with capital from the GGF.

Local VCs

Local VC funds, a.k.a RMB funds, are becoming the major force with over 90% of the new funds raised in 2016 as RMB funds, compared to a mere 10% in 2005.

Faster in decision making. These funds are generally a lot faster in decision making. RMB typically takes half the time (3-5 weeks) to close a deal compared to USD funds (6-10 weeks). This is mainly because most of the local LPs, primarily local high net worth individuals or family offices, demand faster return. Lots of RMB fund are set in a 5+2 model (5-year investment period and 2-year exit period), and the fund managers need to deploy the capital faster than their US peers so that they can see return (hopefully) in a shorter cycle. This flux of local funds has pushed those USD funds to focus more on later stage deals.

Aggressive in valuation. RMB funds tend to offer higher valuation, normally +10-20%, when competing with USD funds on hot deals. The fund managers prefer to demonstrate their capabilities and build up a track record by setting their hands on those high profile deals.

Startups and entrepreneurs

Southern style vs. northern style. Startups in China bear different business culture/style based on their geographical location. Typically, the “southern style” is closer to the traditional way of doing business in China (keep a low profile until you get your product out, then focus on making the business profitable). In contrast, the “northern style” tends to be a lot higher profile and focused on selling the vision to investors right off the bat. This is because southern China traditionally boasts of lower margin manufacturing industries that reward operational excellence, while entrepreneurs from northern China are better at reading the trends. This has established a divide in the types of startups that incubate per region. For example, most successful software startups (like Didi [ride-sharing app] and Toutiao [news app]) are from Beijing, while hardware (like DJI [drones] and JMGO [micro projectors]) are from Shenzhen.

A changing landscape

Tier 1 cities vs. tier 2 cities. Beijing, Shanghai, and Shenzhen are considered the center stage of startups in China due to a historically larger talent pool, sufficient funding, and the open attitude of the local government. However, there has been a recent growth of tier 2 cities due to more aggressive government subsidies to flip these cities into dedicated tech hubs. For example, Hangzhou, the capital of Zhejiang province (also headquarter of Alibaba) is now focusing on e-commerce. Chengdu, the heart of southwest China, picked software and attracted many IT companies (IBM, Microsoft, and SAP) to headquarter regionally there, too. Leading tech firms provide the infrastructure necessary to support a local entrepreneurial ecosystem.

New hot verticals. The growth of China’s economy in the last decade led to a “consumption upgrade” that established strong online shopping habits. Online-to-Offline (O2O) and vertical e-commerce platforms startups flourished following the success of Chinese giants Alibaba and JD.com. But after rounds of capital and multiple merger-of-mergers (like Meituan.com and Dianping.com [two general O2O companies that cover everything from food delivery to hotel booking]), VCs are in search of something new. We see increasing interest in shared economy, SaaS, and artificial intelligence.

Shared economy is growing alongside the population base. Take smart bike-sharing platforms as an example. They have been around for fewer than three years, yet they have significant traction. OFO and Mobike closed over $660 million collectively in their recent rounds of funding and have aggressive plans to expand outside of China. What distinguishes these startups is that they take a familiar idea to customize it to something novel. These Chinese bikes are dockless and mobile-activated, which is a lot more user-friendly and low-friction versus the models in the US.

SaaS companies (especially in the CRM area) that started in the early 2000s are starting to bear fruit. Beijing-based Xiaoshouyi is the Chinese version of Salesforce that just closed a $40 million round in January 2017 after years of market education. Similar to shared economy, the reason why local Chinese SaaS startups can take on those global tycoons, such as Salesforce, is because of localization. For example, Xiaoshouyi has embedded its CRM system in WeChat, one of the most popular social messaging platforms in China. Also, local SaaS companies are more mobile friendly versus western SaaS companies that tend to be more PC-based.

The connected tech community has brought the artificial intelligence trend to the Chinese startup community. Unlike the US, though, the big Chinese AI startups are diverse horizontally and innovate across all industries. Just looking at top AI companies, we have Face++ (facial recognition technology used by Alibaba), Toutiao.com (AI-powered news app with over 700 million users), and iCarbonX (big data platform that’s creating a “Digital You” to predict illness). Due to the unique way of doing business in China, these startups are willing to tackle the harder problems and take on larger regulatory risks. They’re focused more on the growth potential.

So what’s next?

We’ve discussed specific trends regarding industry, regional development, and behavior in China. Historically, China has been known for its “me too” model because it has replicated successful US business models locally (obvious examples are Alibaba/Amazon, Baidu/Google, and Didi/Uber). Now, with stronger government support, ample talent supply, and extensive capital injection, we can expect a change. There’s a huge market for experimenting, and companies are quick to launch and shut. The entire world is waiting to see what the next “big bang” coming out of this black box will be.

Warren is on the Startup Business Development team at AWS in China. Prior to Amazon, Warren spent 7 years working as a strategy consultant advising mainly Fortune 500 clients and 2 years at a buy-out private equity fund in China, focusing on consumer goods and services